March 19, 2021

Physical Distancing in a New Light: The Interplay of Reclamation Rights, the 20-Day Goods Administrative Priority Claim, the Meaning of “Receipt of Goods” under the U.C.C., and Commercial Reality

Mark S. Finkelstein and Regan S. Jones

The authors recently encountered a challenging situation on behalf of our client in seeking to establish a Bankruptcy Code section 503(b)(9) reclamation claim with respect to the client’s sale of goods - in this instance commodity petrochemicals - to a company that acted as a distributor, and that took title to, but not actual physical possession of, the goods.  Instead, as is a common practice where distributors are involved, deliveries were made via railcar transport to a third party “subpurchaser” that took actual physical delivery of the goods within the critical 20-day time period preceding the date that the distributor filed a voluntary chapter 11 bankruptcy case.  Our undertaking was to prove, under this fact scenario, that physical receipt of the goods by the subpurchaser satisfied the requirement that the debtor “received” the goods within the 20-day period sufficient to support our client’s section 503(b)(9) administrative priority claim.  Stated otherwise, the question presented was whether goods actually received by a subpurchaser rather than by the debtor can be deemed to be in the constructive possession of the debtor to support that claim?  This specific legal issue was one of first impression. 

While we believe our position would have prevailed over the contrary position asserted by the chapter 7 trustee (appointed when the case was converted to a chapter 7 case), other issues predominated, including alleged preference claims, and the parties settled the dispute in a global settlement before obtaining a definitive ruling from the court on the administrative expense claim.  Even so, the situation our client faced presents a common fact pattern, and could impact every transaction involving the sale of goods to a distributor that later files bankruptcy.  Indeed, technology and state of the art logistics have transformed the commercial marketplace.  Despite the vast prevalence of commercial relationships in which suppliers engage distributors to arrange resale and direct shipment of goods to third-party subpurchasers, there is a rising concern over whether these suppliers can protect themselves under 11 U.S.C. § 503(b)(9) due to the common misconception that these deliveries are “drop shipments” that are not “received” by the debtor-distributor when delivery is actually made to a subpurchaser.  This article addresses the relevant statutory and case law evaluating the applicability of section 503(b)(9) to this common situation, and advocates that there is ample justification for the allowance of administrative expense claims in the supplier-distributor-subpurchaser context presented.

Introduction

Advances in shipping and alternative business models, such as Amazon’s, have caused numerous commercial relationships to evolve from two party relationships to three or more party relationships.  For instance, it is commonplace for a seller-distributor (party one) to receive an order for widgets from a customer-subpurchaser (party two).  The seller-distributor, though not keeping widgets in stock, will buy widgets from a manufacturer-supplier (party three), but instruct the manufacturer-supplier to ship directly to the seller’s customer rather than to the seller itself.  There may be no underlying contract between the manufacturer-supplier and the customer; rather, each of these parties typically has a separate contractual relationship with the seller-distributor.  The seller-distributor’s bankruptcy will create a quandary:  currently the law is in limbo as to whether suppliers who directly ship the goods to subpurchasers pursuant to the distributor’s delivery instructions can secure an administrative expense claim under Bankruptcy Code section 503(b)(9) in the seller-distributor’s bankruptcy.   If they do not have an administrative expense claim, these suppliers will often be paid only pennies on the dollar for unsecured, non-priority claims.  It is nonsensical to apply differential treatment to the manufacturer-supplier that delivers goods to a distributor for redelivery, as contrasted with the manufacturer-supplier that acts in accordance with the seller-distributor-debtor’s instructions and delivers goods directly to its subpurchaser--thereby helping the debtor fulfill its outstanding contractual obligations.

Pertinent Bankruptcy Code and U.C.C. Provisions and Case Law

If a company files bankruptcy, suppliers of goods may seek allowance of administrative priority claims under Bankruptcy Code section 503(b)(9) for the goods supplied to the debtor in the 20 days prior to the petition date.  An allowed priority claim of this sort yields a greater likelihood of payment.  When Congress enacted section 503(b)(9), it enhanced certain creditors’ rights and expanded the category of administrative expense claims to include the value of goods sold to a debtor in the ordinary course of business and received by the debtor within 20 days before the date of the bankruptcy filing.  11 U.S.C. § 503(b)(9); see In re Escalera Res. Co., 563 B.R. 336, 346 (Bankr. D. Col. 2017).  The statute advances two policy goals: (1) it seeks to encourage creditors to continue extending credit to companies descending into bankruptcy, and (2) it discourages “abuse by debtors who seek to acquire goods at a time when it is known that bankruptcy is imminent and that payment for the goods will not have to be tendered.”  In re Arts Dairy, LLC, 414 B.R. 219, 220 (Bankr. N.D. Ohio 2009) (citation omitted).

In pertinent part, section 503(b)(9) of the Bankruptcy Code states:

(b) After notice and a hearing, there shall be allowed, administrative expenses, other than claims allowed under section 502(f) of this title [11 U.S.C. § 502(f)], including—

. . .

(9) 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 sold to the debtor in the ordinary course of such debtor’s business.

11 U.S.C. § 503(b)(9) (2020).  The Bankruptcy Code’s requirement that the goods be “received” by the debtor has been the focus of many courts addressing section 503(b)(9) administrative expense claims.

Physical vs. Constructive Receipt

Since Congress opted not to define “receipt” in the Bankruptcy Code, courts assess whether goods were “received by the debtor” by reading relevant provisions of Article 2 of the U.C.C. and section 503(b)(9) as a “harmonious whole.”  In re SRC Liquidation, LLC, 573 B.R. 537, 540 (Bankr. D. Del. 2017).

In re Marin Motor Oil, Inc., 740 F.2d 220, 221 (3d Cir. 1984), a case that predates BAPCPA, addressed the concept of reclamation under section 546(c) of the Bankruptcy Code.  In Marin Motor Oil, Montello Oil Corp. (“Montello”) contracted to sell gasoline to Marin Motor Oil, Inc. (“Marin”), and Marin agreed to pay for that gasoline within a day of the gasoline’s delivery and receipt by Marin of a certificate of inspection.  Id. at 222.  The gasoline was retrieved from Montello and transported on a commercial barge operated by a common carrier.  Id.  Eleven days after the gas was delivered to the terminal in which Marin had a terminaling agreement with Cities Service Company’s terminal, Marin filed a chapter 11 bankruptcy petition.  Id.  On the same day, Montello submitted a demand for reclamation pursuant to section 546(c) of the Bankruptcy Code and § 2-702 of the U.C.C.  Id. at 222-23.  Additionally, Montello instituted an adversary proceeding against Marin in the bankruptcy court seeking reclamation of the gasoline.  Id. at 223.  The bankruptcy court granted Marin’s motion for summary judgment on the grounds that (1) the previous state court lawsuit between Montello and Marin and injunction did not constitute a written reclamation demand under section 546(c); and (2) the demand was not timely, because Marin did not receive it within the 10-day period required by section 546(c).  Id.  The district court affirmed summary judgment in favor of Marin, and Montello then appealed.  Id.

On appeal, the Third Circuit noted that section 546(c) was adopted by Congress to resolve whether U.C.C. § 2-702(2) applied when a debtor filed for bankruptcy.  Id.  The drafters of the Bankruptcy Code essentially incorporated U.C.C. § 2-702(2) into the law but added a requirement that sellers must make a written demand for reclamation.  Id.  The court then had to evaluate what constituted “receipt” of the goods under section 546(c)’s 10-day reclamation demand period.  Id. at 224.  The court explained that the Bankruptcy Code does not define “receipt”, and therefore looked to U.C.C. § 2-103(1)(c), which defines the receipt of goods as “taking physical possession of them.”  Id. at 224-25 (citing U.C.C. § 2-103(1)(c)).  Marin took the position that it took possession of the goods at the time in which the risk of loss passed to it; however, the court disagreed and reasoned that this argument is contrary to U.C.C. § 2-103(1)(c) which emphasizes “physical possession” rather than the concept of “title”.  In re Marin Motor Oil, Inc., 740 F.2d at 225.  Additionally, the Third Circuit relied on U.C.C. § 2-705, “which views goods given by a seller to a common carrier for delivery to a buyer as being in the possession of the common carrier not the buyer, and gives the seller the right to stop delivery of the goods upon discovery of the buyer’s insolvency.”  Id.  The court then reasoned that under U.C.C. § 2-705(2), Marin had “constructive possession” of the gasoline once it was delivered to Marin’s bailee.  Id. at 225-26.

After Marin Motor Oil, Inc., other courts began adopting Article 2 of the U.C.C’s definition of “receipt” to define “received” under 11 U.S.C. § 503(b)(9) in the same fashion as it has been used in interpreting “received” under section 546(c).  In re Wezbra Dairy, LLC, 493 B.R. 768, 770-71 (Bankr. N. D. Ind. 2013); In re Circuit City Stores, Inc., 432 B.R. 225, 229 (Bankr. E. D. Va. 2010); In re Momenta, Inc., 455 B.R. 353, 357-59 (Bankr. D. N.H. 2011), aff'd Ningbo Chenglu Paper Products Mfg. Co., Ltd. v. Momenta, Inc., 2012 U.S. Dist. LEXIS 122615, 2012 WL 3765171 (D. N.H. Aug. 29, 2012).  

While courts have been willing to rely on the U.C.C. for clarification in the Bankruptcy Code, they have seemingly ignored the Official Comments to the U.C.C.  For example, the Bankruptcy Court for the District of New Hampshire was tasked with determining whether a trade creditor’s “drop shipments” to a debtor’s customer were eligible for administrative expense recovery under section 503(b)(9).  In re Momenta, Inc., 455 B.R. 353, 356 (Bankr. D. N.H. 2011) (hereinafter “Momenta I”).  Importantly, there was no record as to what happened to the drop shipments when they were delivered to their designated destinations.  Id.  Ningbo, the creditor, argued that receipt under the U.C.C. includes possession by a “third party purchaser.”  Id. at 359.  In evaluating “receipt” for section 503(b)(9), the court noted that under U.C.C. § 2-705(2), three out of four events involved a form of “constructive receipt”, and therefore, under the U.C.C. “receipt” includes constructive possession.  Id. at 360.  The court further reasoned that this definition would apply to section 503(b)(9) because of its interrelatedness to section 546(c).  Following this rationale, the court aptly noted that “a seller may have an administrative expense claim in a drop shipment situation, so long as the debtor at some point had constructive possession of the goods.”  Id.  Unfortunately for Ningbo, the record had no evidence to suggest either physical or constructive possession in the drop shipment transactions, and it therefore had no section 503(b)(9) administrative expense claims for these shipments.  Id. at 361.

On appeal, the District Court for the District of New Hampshire affirmed the bankruptcy court’s ruling that Ningbo did not have section 503(b)(9) administrative expense claims for the drop shipped goods; however, the district court seemingly ignored the fact that the record in the bankruptcy case did not explain what happened to these shipments, such as whether they were “placed in a warehouse, held by a customs agent, delivered to a common carrier, held by a bailee, etc.”  Id. at 356.  Instead, the district court errantly misstated, “The bankruptcy court also correctly held that, under section 503(b)(9), delivery to, or possession by, a debtor’s customer under a drop-shipment arrangement does not constitute constructive possession by the debtor. . .” Ningbo Chenglu Paper Products Mfg. Co., Ltd. v. Momenta, Inc., 2012 U.S. Dist. LEXIS 122615 at *18 (hereinafter “Momenta II”). Cf. Momenta I, 455 B.R. at 360-61 (“if the Debtor had physical or constructive possession of any goods delivered in a drop shipment, within the meaning of U.C.C. § 2-705(2) . . . Ningbo may have an administrative claim under § 503(b)(9)”).  The district court explained that Congress intended to expand the rights of reclamation creditors with the adoption of section 503(b)(9), but did not intend to create an “expansive creditor class entitled to a unique priority” under section 503(b)(9).  Momenta II, 2012 U.S. Dist. LEXIS 122615 at *14-15.  On appeal, Ningbo brought to the court’s attention Official Comment 2 to U.C.C. § 2-705(2)(a), which specifically speaks about receipt by a buyer’s subpurchaser.  Unfortunately, the district court dismissed this argument because while it may reflect the commercial reality, “the statutory construction it proposes here does not fit the context” for the enactment of section 503(b)(9).  Id. at *11.  The court’s hesitation stemmed from the notion that before the enactment of the BAPCPA, “administrative expense priority served as an alternative remedy to reclamation.”  Id. at *13 (citing In re Microwave Prods. of Am., Inc., 94 B.R. 967, 970 (Bankr. W.D. Tenn. 1989)).  Ningbo’s argument deserved a more favorable consideration.

In 2017, courts began to refocus on the “receipt” issue under section 503(b)(9).   The Third Circuit in World Imports recognized that the term “received” under section 503(b)(9) has the same meaning as it does under Article 2 of the U.C.C..  In re World Imps., Ltd., 862 F.3d 338, 342-43 (3d Cir. 2017).  The World Imports court explained, “there is ample evidence from the statutory context that Congress relied on the U.C.C. definition of the word [‘received’].”  Id. at 342.  The World Imports court relied upon its reasoning in Marin Motor Oil and held that the term received “as used in 11 U.S.C. § 503(b)(9) requires physical possession by the buyer or his agent.”   Id. at 346 (emphasis added).   Since “Article 2 of the UCC governed sales of goods in 49 states when 11 U.S.C. § 503(b)(9) was adopted,” the court inferred that Congress meant to adopt the U.C.C.’s “‘well known meaning’ of the term [‘received’].”  Id. at 342. However, the World Imports case did not discuss Official Comment 2 to U.C.C. section 2-705, which states:

 

“Receipt by the buyer” includes receipt 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 is thus barred from stoppage of the goods as against him.

 

U.C.C. § 2-705, cmt. 2.

Around the same time in 2017 the bankruptcy court for the Eastern District of Michigan addressed whether “receipt” under section 503(b)(9) could be effectuated by a nonemployee of the debtor that ordered the goods.  In re VPH Pharm. Inc., 578 B.R. 776 (Bankr. E.D. Mich. 2017). Following Momenta I, 455 B.R. 353, 360-61 (Bankr. D.N.H. 2011) and In re World Imps., Ltd., 862 F.3d 338 (3d Cir. 2017), the VPH Pharm court held that “receipt” under section 503(b)(9) could be effectuated by the debtor or its agent.  Id. at 780. 

The VPH Pharm court reasoned that neither section 503(b)(9), case law, nor the normal course of business requires a “direct buyer-seller arrangement”, and that section 503(b)(9) merely requires “goods received by the debtor.”   Id. at 781.  Similarly, the VPH Pharm court observed that to adopt the trustee’s rationale would eliminate the ability of a seller of goods to obtain section 503(b)(9) status for any transaction involving a third party.  Id.  “Anything short of the seller delivering to the buyer, in the Trustee's eyes, is fatal. These types of transactions are few and far between in American commerce today because many different people or companies are involved in the sale, delivery, and receipt of goods.” Id. (emphasis in original).  In sum, the VPH Pharm court held that the requirement of “receipt” of the goods was met because the  non-employee individuals received the goods on behalf of VPH as either its employees or agents at the approved delivery location designated by the debtor.  Id. at 780-781.

Additionally, the VPH Pharm court concluded that adopting the trustee’s logic for requiring proof of agency would defeat one of the purposes of section 503(b)(9) – to encourage sellers to continue to do business with financially distressed buyers.  Id. at 781.  If delivery to a debtor’s agent does not satisfy the “receipt” requirement of section 503(b)(9), “commerce would grind to a halt and another reason would be handed a seller to not sell to a distressed Chapter 11 debtor.”  Id.  The court further noted that if the goods were not received by VPH, then VPH would have complained that the arrangements were breached.  VPH made no such complaint.  Id. at 780.

In re ADI Liquidation, Inc., 572 B.R. 543 (Bankr. D. Del. 2017), considered  whether AWI “received” goods from supplier Bimbo Bakeries USA, Inc (“BBU”) within the meaning of section 503(b)(9) when AWI was not actually a purchaser, but instead functioned as a broker for the AWI Members, and AWI took neither title to nor possession of the goods.  Id. at 545.  To prevail, supplier BBU had to prove (1) goods were received by AWI within 20 days before the petition date, (2) goods were sold to AWI, and (3) the goods were sold in the ordinary course of business.  Id. at 548.  Judge Carey concluded BBU failed to prove element (1) and granted AWI's motion for summary judgment.  Judge Carey’s decision turned on whether AWI was the purchaser.  It was not.  Instead, the AWI Members were the purchasers, and they were explicitly not subpurchasers, because under the particular facts of the case, AWI itself was not a purchaser of the goods from the supplier.  Id. at 550, n.35. AWI also made a strong argument that the second section 503(b)(9) element—requiring that the goods be sold to AWI— had also not been satisfied.   By Judge Carey’s own statement, constructive receipt by a third party that satisfies section 503(b)(9) and U.C.C. § 2-705, Comment 2 is not limited to those instances in which delivery is to a third party that constitutes a bailee.  Judge Carey explained that his decision may superficially seem at odds with U.C.C. § 2-705, Comment 2; however, his decision is not inapposite because the “buyers” in BBU were the AWI Members, and that case did not entail a subpurchaser arrangement whereby AWI bought the goods from BBU for resale.  Id.  

On appeal, the district court affirmed Judge Carey’s decision that BBU failed to satisfy the requirements of administrative priority under section 503(b)(9) because AWI did not itself receive the goods in question.  Bimbo Bakeries USA, Inc. v. AW Liquidation, Inc. (In re ADI Liquidation, Inc.), 2019 US Dist. LEXIS 7418, *14 (D. Del. Jan. 16, 2019).   In pertinent part, the court emphasized that BBU was not a party to the purchase and sale agreements (PSAs) between AWI and the AWI Members, and that BBU did not offer any evidence to show that its deliveries to the AWI Members were covered by those PSAs.  Id. at *10.  Additionally, the AWI Members were not subpurchasers; they directly bought the goods from BBU.  Id.  Viewed properly, the case reflects the distinction between a distributor, which buys and resells goods (or sells and then buys goods), and a broker such as AWI, which merely arranges a sale between seller and buyer, with the broker taking neither title to nor, in the usual circumstance, possession of the goods.

The most recent cases addressing receipt under section 503(b)(9) came into fruition in the bankruptcy court for the District of Connecticut in 2019.  Judge Manning, the chief bankruptcy judge, addressed the issue in three cases stemming from the bankruptcy of an international group of global marine fuel companies.  The three opinions have largely the same substance, so this article will address only In re O.W. Bunker Holding N. Am. Inc., 607 B.R. 32 (Bankr. D. Conn. 2019).  In that case, Judge Manning addressed whether OWB USA, the debtor, “received” the fuel under section 503(b)(9) vis-à-vis the contracts with the vessels.  Id. at 35.  The court granted supplier O’Rourke’s motion for summary judgment and allowed it an administrative expense claim.  Judge Manning cited to the Official Comment to U.C.C. § 2-705, which expands the definition of “receipt by the buyer” to include “receipt by the buyer’s designated representative, the sub-purchaser, when the shipment is made direct to him and the buyer himself never receives the goods. . .”  Id. at 38 (citing U.C.C. § 2-705, at cmt. 2). 

While Judge Manning cited to the statement in Momenta II that under section 503(b)(9), drop-shipment deliveries do not constitute constructive receipt, she later explicitly noted that the Momenta I bankruptcy court “held that the record failed to establish whether the debtor had any physical or constructive possession of the Drop Shipments . . . the court stated that constructive possession of the goods could be deemed to be ‘receipt by the debtor’ for the purposes of § 503(b)(9)”.  In re O.W. Bunker Holding N. Am. Inc., 607 B.R.at 39.  Significantly, Judge Manning did not expressly or implicitly rule that drop shipment arrangements were fatal to section 503(b)(9) claims.

The court allowed O’Rourke an administrative expense claim in part because each of the vessels was a bailee of OWB USA.   Id. at 44.  The decision hinged on the contractual language between OW and the vessels, which explicitly provided that, “Buyer agreed that it is in possession of the Bunkers solely as Bailee for the Seller, and shall not be entitled to use the Bunkers other than for the propulsion of the Vessel. . .”  Id. (emphasis in original). 

Judge Manning relied on the United Kingdom’s Supreme Court’s decision in Res Cogitans, whereby the bailment structure was determinative.  Id. at 45-46.  The court reasoned that as bailees, the vessels took possession, but not title to the fuel, and they were “permitted to consume the fuel for the sole purpose of propulsion.”  Id. at 46.  The debtor was deemed to be in constructive possession of the fuel when O’Rourke delivered the fuel to the vessels.  The court explained that O’Rourke’s reclamation right ended when the vessels took control of the fuel as bailee for the debtor, and then used the fuel for its permitted use, propulsion.  Id.

Conclusion

The majority of the decisions above have not fully considered or embraced the Official Comments to the U.C.C., and in turn, have created a divergence between section 503(b)(9) analysis and the realities of contemporary commercial business transactions, and potential unfair treatment of sellers of goods. To have a company successfully reorganize under chapter 11 of the Bankruptcy Code, it is vital that the company’s business partners continue their relationships with the company entering bankruptcy.  Because suppliers and vendors directly benefit the bankruptcy estate by fulfilling the bankrupt company’s contracts with its customers, thereby encouraging customers to continue doing business with the bankrupt company, and preventing the bankrupt company from incurring additional liability if it breaches its contracts, it is entirely appropriate for courts to ensure that these suppliers are granted allowed administrative priority expenses under section 503(b)(9).  It is nonsensical to hold that a bankrupt company’s subpurchaser cannot “receive” goods by virtue of contracts between the bankrupt company and the supplier, whereby the benefits of this transaction directly flow back to the bankrupt company in its role as purchaser-reseller-distributor.  The position advocated in this article is supported by both Official Comment 2 to U.C.C. § 2-705, the better-reasoned authorities cited above, and the equitable underpinnings of the Bankruptcy Code.

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    Mark S. Finkelstein

    Shareholder, Shannon, Martin, Finkelstein, Alvarado & Dunne, P.C.

    Mark S. Finkelstein is a shareholder at Shannon, Martin, Finkelstein, Alvarado & Dunne, P.C. and leads the firm’s Bankruptcy, Creditors’ Rights, and Commercial Litigation practice groups. 

    Regan S. Jones

    Associate, Shannon, Martin, Finkelstein, Alvarado & Dunne, P.C.