Delaware’s Bankruptcy Court has recently issued two insightful opinions that impact a creditor’s ability to establish the “receipt” element of a valuable 503(b)(9) administrative expense priority claim.

CASE 1: In re SRC Liquidation, LLC, Case No. 15-10541, 2017 WL 2992718 (Bankr. D. Del. July 13, 2017)

On July 13, 2017, Chief Judge Shannon of the United States Bankruptcy Court for the District of Delaware issued an opinion in the In re SRC Liquidation, LLC bankruptcy case regarding the ability of a creditor to assert a Section 503(b)(9) administrative claim for goods shipped by the vendor directly to a debtor’s customer in the 20 days before a debtor’s bankruptcy – referred to as “drop shipping.”

As discussed in prior posts on 503(b)(9) claims (Getting the Most Bang for Your 503(b)(9) Claims and Section 503(b)(9) Claims – What Does “Receipt” Really Mean?), to establish a 503(b)(9) claim, a creditor must demonstrate that:

  • goods were received by a debtor within 20 days before the petition date;
  • the goods were sold to the debtor; and
  • the goods were sold in the ordinary course of business.

The critical consideration in the SRC Liquidation decision was whether the creditor could establish that the debtor “received” the goods for purposes of establishing that its claim was entitled to administrative treatment pursuant to  Section 503(b)(9) of the Bankruptcy Code.  If not – the claim would be relegated to a non-priority, general unsecured claim (with little chance for recovery).  The creditor asserted that receipt occurred when the creditor-vendor delivered the product to a third-party shipper (UPS) for ultimate delivery to the debtors’ non-debtor customer.  By example, with most drop shipments, a debtor may directly place an order with a creditor-vendor, but the creditor-vendor may deliver the goods directly to a debtor’s customer, rather than the debtor itself.

In SRC Liquidation, the court’s analysis began with recognizing that “receipt” is not defined in the Bankruptcy Code and looking to the UCC for guidance.  Under the UCC, the term “receipt” can include physical possession (see § 2-103) or, in certain circumstances, constructive possession (i.e. § 2-705) when placed in the control of a bailee for the debtor.  The United States Court of Appeals for the Third Circuit in its recent opinion in In re World Imports, Inc., was also recently tasked with defining receipt for purposes of 503(b)(9) claims.  There, the Third Circuit, just days prior to Judge Shannon’s SRC Liquidation decision, held that receipt for purposes of 503(b)(9) claims required physical possession – and the Third Circuit looked to both its prior precedent in the case of Montello Oil Corp. v. Marin Motor Oil, Inc. (In re Marin Motor Oil, Inc.), 740 F.2d 220 (3d Cir. 1984) (where receipt for reclamation purposes was found to require physical possession) and the UCC.  The Third Circuit in In re World Imports, Inc. also noted that in analyzing shipping arrangements, placement of the goods into the possession of a common carrier (who was not the debtor’s bailee) did not establish “receipt” –instead observing it occurred when the debtor physically received the goods.

The creditor in In re SRC Liquidation argued that receipt for purposes of 503(b)(9) should be interpreted to include constructive receipt – including by a debtor’s customers.  The creditor argued that the court should interpret the term “received” differently when considering it under 503(b)(9) as opposed to reclamation because the commercial realities and the remedies are different.  The creditor argued that for reclamation, because the remedy is recovery of actual goods delivered, physical possession of the goods would understandably be a prerequisite, while in contrast for a 503(b)(9) claim, a creditor is asserting a claim for the value of the goods – not for the actual goods – and thus constructive possession should be permitted.  A focal point of the creditor’s argument was that “receipt” for 503(b)(9) purposes should be determined when title passed from the seller – i.e. when placed with the third-party shipper.

The bankruptcy court disagreed finding that the term “received” should mean the same for reclamation as for 503(b)(9) purposes because they arise in similar circumstances and concern related issues.  The court further held that the passing of title was not the only concern – particularly under the UCC – for establishing rights of buyers and sellers – noting that “possession is the key.”   Judge Shannon cited the Third Circuit’s decision just days in In re World Imports, Inc.   My recent prior post provides a more in-depth analysis of that decision, where the Third Circuit held that physical possession by the debtor was determinative of whether the debtor “received” goods for 503(b)(9) purposes, as opposed to the when title or of loss of product passed.    

Judge Shannon’s decision was not appealed and appears to follow the majority of other courts that have addressed the drop shipment issue (including Judge Shannon’s prior findings in the SRC case).  The majority of courts hold that unless the actual debtor-customer (as opposed to another party) received the goods, the claim for such goods is not entitled to administrative expense priority treatment under Section 503(b)(9) of the Bankruptcy Code.  See, e.g., In re SRC Liquidation Co., No. 15-10541(BLS) (Bankr. D. Del. Oct. 15, 2015) (transcript of bench ruling) (“[W]hile it may be a business relationship developed of long practice and, frankly, for the benefit and at the direction of the Debtor, nevertheless, the circumstances of that business relationship and the way product was moved from one party to another is such that it takes it outside of the scope of Section 503(b)(9).”); In re Plastech Engineered Prods., Inc., No. 08-42417, 2008 WL 5233014, at *1 (Bankr. E.D. Mich. Oct. 7, 2008) (sustaining debtors’ objection to 503(b)(9) claim for goods delivered directly to debtor’s customer); Ningbo Chenglu Paper Prods. Manuf. Co., Ltd. v. Momenta, Inc. (In re Momenta, Inc.), No. 11-cv-479-SM, 2014 WL 3765171, at *7 (D.N.H. Aug. 29, 2012) (same).  The ultimate implication of this ruling is best considered in the context of the In re ADI Liquidation, Inc., et al. decision issued in June 2017 and discussed below.

CASE 2: In re ADI Liquidation, Inc., et al., Case No. 14-12092, 2017 WL 2712287 (Bankr. D. Del. June 22, 2017)

Last month, on June 22, 2017, Judge Carey of the United States Bankruptcy Court for the District of Delaware issued an opinion in the In re ADI Liquidation, Inc., et al. cases addressing what “received” means in the context of a Section 503(b)(9)  claim derived from a wholesale arrangement – which he analogized to a drop shipment arrangement.   Wholesale/cooperative arrangements are prevalent in and outside of the grocery industry.  In cooperatives, typically member-participants collectively order through a centralized billing system and typically the orders are all made by and through one entity to vendors (and that entity also pays for the goods), but the shipments are often made directly to the member-participants (as opposed to the ordering party), who then pay the ordering party after the fact.  Cooperatives often arise where buyers, who purchase the same products or purchase from the same vendors, pool their buying power to negotiate more favorable rates.

In the ADI Liquidation case, creditor Bimbo Bakeries USA, Inc. (“BBU”) supplied baked goods to AWI (f/k/a Associated Wholesalers, Inc.) and to its cooperative members (which included non-debtor entities).  The ordered goods were delivered directly to AWI as well as directly to the non-debtor cooperative members.  AWI would typically pay vendors for all of the purchased goods (by both AWI and its cooperative members).  There was a separate purchase and supply agreement between the members and AWI, pursuant to which AWI acted as a wholesaler to the members.  BBU as a vendor was not a party to the purchase agreement.

When BBU asserted its Section 503(b)(9) claims, it included goods delivered directly to debtor AWI and goods that BBU delivered to the non-debtor AWI Members (that were ordered and paid for by AWI).  As discussed above and in my prior posts on 503(b)(9) claims, to establish a 503(b)(9) claim, a creditor must demonstrate, among other things, that the goods were received by a debtor within 20 days before the petition date.

The central focus of the court’s opinion in In re ADI Liquidation was whether or not BBU established that the AWI debtors “received” the goods that BBU delivered to the non-debtor cooperative members.  BBU argued that the goods in question were constructively received by debtor AWI (and thus entitled to administrative expense treatment under Section 503(b)(9) because debtor AWI and the non-debtor receiving members/customers were so related and indivisible, that the receipt by the customer was the equivalent of the debtor receiving it.  The court’s instant decision did not address BBU’s other claims – including administrative expense claims for goods delivered to other debtors, but ordered by AWI.

Recognizing (as referenced above) that the term “received” is not defined by the Bankruptcy Code, the court looked to the UCC for guidance and found that for constructive receipt to be established (often considered in the context of reclamation), the receiving party must be a bailee of the debtor.  The court held that the receiving members were not bailees of debtor AWI and notwithstanding that the UCC contemplates that constructive receipt can occur by a buyer-representative who is a “sub-purchaser” (like in a drop ship context), the court held that the “buyers” were the non-debtor members and not debtor AWI.  In so finding, the court determined that the claims for the goods that BBU delivered to the non-debtor members were non-priority, general unsecured claims (which would receive little, if any distribution).

On July 5, 2017, BBU appealed the Delaware Bankruptcy Court’s June 2017 decision to the District Court (assigned Case No. 17-903).   Given the prevalence of cooperative buying arrangements, in and outside of the grocery context, and the importance of “receipt” in establishing the very valuable 503(b)(9) claims, creditors and debtors alike will be carefully monitoring the developments of this case.

CONCLUSION

As discussed in prior posts, Section 503(b)(9) claims are very valuable to creditors (with the likelihood of providing a dollar for dollar return) as opposed to other general unsecured claims which often times provide speculative, if any, return.  These recent decisions on the receipt element for establishing a Section 503(b)(9) claim provide helpful guidance so that debtors, creditors and their respective professionals can better understand the prospects for establishing these administrative claims, and in particular for debtors, the cost of confirming a bankruptcy case – which requires payment in full for such claims.