Sales of inventory: Third Circuit clarifies the meaning of “received” under section 503(b)(9) of the Bankruptcy Code

In an era of e-commerce, a glut of shopping malls, and a change in consumer spending habits, many distressed brick-and-mortar retailers are closing stores and liquidating their businesses. So far in 2017, major retailers, including Toys “R” Us, The Limited, Wet Seal, Eastern Outfitters, BCBG Max Azria, HhGregg, Radio Shack, Gander Mountain, Payless ShoeSource, Rue21, and Gymboree, are filing for chapter 11 bankruptcy protection at a record pace. Many distressed retailers seek a buyer for their assets, or to restructure their debt, but the reality is that many retailers will have to shut their doors and liquidate their assets. These bankruptcies affect vendors and suppliers of goods to distressed buyers because they face payment of pennies on the dollar for their claims.

A 2005 amendment to the Bankruptcy Code provides a limited measure of protection to vendors who ship to a customer on the verge of Chapter 11 but two recent decisions have clarified the scope of that protection. The United States Court of Appeals for the Third Circuit and the United States Bankruptcy Court for the District of Delaware ruled on the definition of “received” in the context of 11 U.S.C. § 503(b)(9). In an unprecedented opinion decided on July 10, 2017, the Third Circuit inIn re World Imports, Ltd.held that to qualify for an administrative expense claim under Section 503(b)(9), “goods received” means physical possession by the debtor or its agent within 20 days of a bankruptcy filing. 2017 WL 2925429 (3d Cir. July 10, 2017). Three days later on July 13, 2017, the Delaware Bankruptcy Court cited the Third Circuit’s decision and similarly held that a vendor shipping goods directly to a debtor’s customers does not qualify for an administrative expense claim under section 503(b)(9) because “received” means physical possession by the debtor. 2017 WL 2992718 (Bankr. D. Del. July 13, 2017). These decisions have widespread implications for vendors that do business on a global scale and that sell goods to a debtor shortly before the debtor files for Chapter 11 bankruptcy petition.

Background of section 503(b)(9)

Section 503(b)(9) was added to the Bankruptcy Code as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Section 503(b)(9) was created as an alternative remedy for sellers of goods in addition to their reclamation rights. Section 503(b)(9) is interrelated to section 546(c) (dealing with reclamation rights) because: (1) it adds an administrative expense claim for the value of goods received by the debtor in the 20 days prior to the bankruptcy filing as an exemption from section 546(c)’s reclamation conditions; and (2) it is available to sellers of goods whether or not they meet the requirements for a reclamation claim or fail to assert their reclamation rights. See 11 U.S.C.A§ 546(c)(2) (“If a seller of goods fails to provide notice. . . the seller still may assert the rights contained in section 503(b)(9).”). Section 503(b)(9) had the effect of taking a seller’s low priority general unsecured, which generally receive payment of pennies on the dollar under a debtor’s chapter 11 plan, and elevating it to a high-priority administrative expense claim that a debtor must pay in full as a condition to confirmation of a chapter 11 plan.

Requirements of section 503(b)(9)

Under section 503(b)(9), a creditor may recover as a priority administrative expense the value of goods if the creditor sold those goods to the debtor in ordinary course of the debtor’s business within 20 days prior to its bankruptcy filing:

(b) After notice and a hearing, there shall be allowed administrative expenses ... including–

(9) the value of any goods received by the debtor within 20 days before the date of commencement of a case under [title 11] in which the goods have been sold to the debtor in the ordinary course of such debtor’s business.

The Bankruptcy Code does not define the operative word “received” in the context of section 503(b)(9), which has given rise to several interpretations of when receipt occurs.

In re World Imports, Ltd. et al, 2017 WL 2925429 (3d Cir. July 10, 2017)

Background

World Imports, Ltd. purchased furniture from two Chinese companies, Haining Wansheng Sofa Company and Fujian Zhangzhou Foreign Trade Company (collectively, the “Creditors”). The Creditors shipped the goods via common carrier from China to the US “free on board” (“FOB”) at the port of origin, which means that the risk of loss or damage to the goods passed to World Imports once the goods were delivered to the common carrier at the port. The Haining goods were shipped on May 26, 2013, and World Imports took physical possession of the goods on June 21, 2013. The Fujian goods were shipped on three separate dates during the period May 17 to June 7, 2013, and World Imports took physical possession of the goods on a date within 20 days of July 3, 2013 (the “petition date”), the date World Imports filed its voluntary Chapter 11 petition in the US Bankruptcy Court for the Eastern District of Pennsylvania.

The Creditors filed motions with the Bankruptcy Court seeking allowance and payment of their claims as an administrative expense under section 503(b)(9) of the Bankruptcy Code. The parties agreed that the Creditors shipped the goods from China more than 20 days before the petition date and that World Imports took physical possession of the goods in the US fewer than 20 days before the petition. However, they disagreed about whether the shipment or physical possession of the goods constituted receipt under section 503(b)(9). The Creditors argued that receipt occurred when World Imports took physical possession of the goods during the 20 days preceding the petition date. World Imports asserted that constructive receipt occurred when the good were delivered FOB to its common carrier. The Bankruptcy Court agreed with World Imports and denied the Creditors’ motion, concluding that the goods were “constructively received” when they were shipped from China. On appeal, the US District Court for the Eastern District of Pennsylvania affirmed the Bankruptcy Court’s decision.

At issue on appeal to the Third Circuit was the definition of the term “received” as used in section 503(b)(9). If World Imports received the goods when they were delivered to the common carrier in China, then the Creditors’ claim for administrative expense priority would fail. If the goods were instead considered “received” when World Imports took physical possession of them in the US, then the Creditors’ claim would receive administrative expense priority.

Holding

The Third Circuit agreed with the Creditors that the goods were not received by World Imports until it took physical possession of them. The Third Circuit reversed the District Court’s decision, allowed the Creditors’ administrative expense claims, and held that receipt under section 503(b)(9) requires physical possession by a debtor or its agent. The Third Circuit analyzed section 503(b)(9), its legislative history, and its relation to section 546(c), a provision that allows a shipper to reclaim goods sold to an insolvent debtor within 45 days of the debtor’s receipt of the goods. The Third Circuit first considered Black’s Law Dictionary which defines “receive” as “[t]o take ...; to come into possession of or get from some outside source.” Black’s Law Dictionary (10th ed. 2014). The Third Circuit next considered Article 2 of the Uniform Commercial Code, which governs the sale of goods, for the definition of receipt. Section 2-103(1)(c) defines the receipt of goods as “taking physical possession of them.” The Third Circuit then analyzed the interrelationship between section 503(b)(9) and section 546(c), finding that section 503(b)(9) should be read and interpreted consistent with section 546(c) because it provided an alternative remedy to reclamation. Lastly, the Third Circuit considered its decision in In re Marin Motor Oil when it held that the word “receipt” in section 546(c) meant the same thing as the UCC’s definition- “taking physical possession.” 740 F.2d 220 (3d Cir. 1984). Because “received” in section 503(b)(9) and “receipt” in section 546(c) are functionally equivalent and used in the same statutory context, the Third Circuit reasoned that they should be treated identically and that the UCC’s definition must also be applied to section 503(b)(9). The Third Circuit also addressed World Imports’s argument that the goods were constructively received when delivered FOB to the common carrier. The Third Circuit held that while a buyer may be deemed to have received goods when its agent takes physical possession of them, common carriers are not agents. Therefore, constructive receipt does not include FOB delivery to a common carrier. The Third Circuit concluded that receipt under section 503(b)(9) requires physical possession by the debtor or its agent and that World Imports took physical possession of the goods within the 20-day period prior to the Petition Date.

In re SRC Liquidation, LLC, 2017 WL 2992718 (Bankr. D. Del. July 13, 2017)

Background

Three days after the In re World Imports opinion, the Delaware Bankruptcy Court applied the Third Circuit’s holding to a different set of facts. International Imaging Materials, Inc. (“IIMAK”) was a vendor to Standard Register Company (n/k/a SRC Liquidation, LLC), and filed an administrative expense priority claim under section 503(b)(9) for the value of its shipped goods. IIMAK delivered its products at times to the Debtor and at other times delivered its products directly to the Debtor’s customers, commonly referred to as “drop shipping,” at the Debtor’s direction, and using the Debtor’s account with United Parcel Service (“UPS”). The parties agreed that the goods delivered by IIMAK directly to the Debtor occurred during the 20-day period before the Debtor filed its Chapter 11 bankruptcy petition. The parties also agreed that the goods delivered by IIMAK to the Debtor’s customers occurred during the relevant 20-day period. The parties disagreed about whether the goods drop-shipped to the Debtor’s customers during the 20-day period constituted “receipt” by the Debtor under section 503(b)(9). The Debtor argued that the drop-shipped goods were never in its physical possession and were not “received” as required by section 503(b)(9). IIMAK argued that given the commercial realities, such as the variety of shipping procedures between vendors, debtors, and their customers, the definition of receipt should not be so narrowly construed, and only the transfer of title to UPS could appropriately determine when the Debtor received the goods under section 503(b)(9).

Holding

The Delaware Bankruptcy Court rejected IIMAK’s argument, noting that “the U.C.C. does not rely on the concept of title for purposes of establishing rights of buyers and sellers: possession is the key.” The Delaware Bankruptcy Court sustained the Debtor’s objection to IIMAK’s claim, citing the Third Circuit’s recent decision, and held that physical possession by the Debtor or its agent, not the passing of title, determined when the Debtor “received” goods for purposes of section 503(b)(9). The Delaware Bankruptcy Court, similar to the Third Circuit, analyzed the legislative history of section 503(b)(9) and looked to UCC § 2-103(1)(c)) and section 546(c) to find that “receipt” should be interpreted to mean “physical possession.” Accordingly, the Court concluded that only UPS as common carrier, and not the Debtor, ever physically possessed the goods, and that UPS was not the Debtor’s agent. Therefore, the Debtor never received the goods drop-shipped to its customers from IIMAK within the meaning of section 503(b)(9).

Practical/real world implications

The Honorable Thomas M. Hardiman of the Third Circuit began his opinion in World Imports, “This appeal involves a question of bankruptcy law that has important ramifications for a creditor that sells goods to a debtor soon before the debtor files a Chapter 11 bankruptcy petition.” The Third Circuit holding, which is binding in Delaware, New Jersey and Pennsylvania, and the Delaware Bankruptcy Court’s holding, have significant implications for vendors who sell to customers that file for Chapter 11 bankruptcy protection. These holdings will also have broad, nationwide effect because Delaware is a preferred venue for many bankruptcy cases.

The Third Circuit’s decision defines when a debtor receives goods and when a vendor’s claim therefore qualifies for administrative expense priority. The holding will help vendors whose goods are in transit for an extended period of time because there is an increased likelihood that the goods shipped to the debtor will arrive during the relevant 20-day period under section 503(b)(9). International vendors that ship goods from long distances, where several weeks pass between shipment and the debtors’ taking possession of the goods, will see the greatest benefit because a debtor’s receipt of the goods will be determined on the later date of physical possession rather than the earlier date of delivery of the goods to a common carrier. These claims will now have high priority as an administrative expense claim, the same priority afforded to the debtor’s attorneys. This holding may benefit retailers and their unsecured creditors because foreign vendors may be more inclined to continue selling goods with a long transit period to a distressed retailer if they are entitled to an administrative expense claim.

While the Third Circuit’s holding is good news for some vendors, the Delaware Bankruptcy Court’s holding created a bright line rule that vendors that ship goods directly to the debtor’s customers do not qualify for an administrative expense claim under 503(b)(9). This will make vendors reluctant to drop-ship goods to financially distressed customers. Vendors may even insist on some form of credit protection (e.g., payment in advance, cash on delivery, or a letter of credit) before they drop-ship goods to such a debtor’s customers.