Feb 22, 2018

Third Circuit holds that vendor must have physical possession of goods for administrative expense priority claim pursuant to Section 503(b)(9) of the Bankruptcy Code

In a recent opinion, the Court of Appeals for the Third Circuit reversed the lower courts’ rulings by holding that a debtor “receives” goods for purposes of section 503(b)(9) of the Bankruptcy Code when the debtor obtains physical possession of those goods. In re World Imports, Ltd., read the full opinion here.

The Third Circuit examined section 503(b)(9) of the Bankruptcy Code, together with section 546(c) of the Bankruptcy Code and the correlating non-bankruptcy law. Section 503(b)(9) of the Bankruptcy Code provides vendors with an administrative expense priority claim for the value of goods received by a debtor during the 20-day period prior to the petition date.

As such, vendor claims that do not satisfy the conditions of section 503(b)(9) are usually regarded as general unsecured claims, thereby receiving only a pro rata share of the debtor’s unencumbered assets. Section 546(c) of the Bankruptcy Code provides that a seller of goods, with certain exceptions, may reclaim goods from a debtor if received while insolvent and within 45 days of the bankruptcy filing.[1]

In this case, the debtor bought goods from two vendors who shipped goods to the debtor more than 20 days prior to the petition date. Notably, certain goods were shipped directly to the debtor’s customers Drop-Shipped, while other goods were shipped to the debtor. All of the goods at issue were received by the debtor or its customers within the 20-day period prior to the petition date.

Once debtor filed for bankruptcy, the vendors claimed an administrative expense priority under section 503(b)(9) alleging that the goods were received upon delivery to the debtor or customer. In contrast, the debtor argued it received the goods when title passed to the debtor upon shipment, which was prior to the 20-day time period. The word “received” is not defined in the Bankruptcy Code.

In ruling in favor of the debtor, the Bankruptcy Court held that the law governing the sale, in this case the Convention on Contracts for the International Sale of Goods, should determine the meaning of the term “received.” As a result, the court found the debtor constructively received the goods when they were shipped, which was more than 20 days prior to the petition date, except for the Drop-Shipped goods, which were never received by the debtor. Thus, the Bankruptcy Court held that the vendors were not entitled to an administrative expense priority under section 503(b)(9). The District Court affirmed the ruling and the vendors appealed to the Third Circuit.

In reversing the lower court rulings, the Third Circuit explained the Uniform Commercial Code, which characterizes the receipt of goods as taking physical possession of them, is the appropriate source of law to determine the meaning of “received.” The court also clarified that the meaning of such a term should not be determined on a case-by-case basis but should be consistent regardless of the terms of the underlying transaction. Thus, the court concluded that the debtor physically received the goods that were not Drop-Shipped within 20 days of the petition date, which entitled the vendors to administrative expense priority pursuant to section 503(b)(9). The Third Circuit did not address the Bankruptcy Court’s ruling that the Drop-Shipped goods were not received by the debtor pursuant to section 503(b)(9), as it was not appealed.

Significantly, In re World Imports was the first circuit court decision on this issue. It remains to be seen as to whether courts outside of the Third Circuit will agree with the World Imports analysis and holding.

The Banking law attorneys of Chuhak & Tecson will continue to follow and report on this issue and will inform of the developing impact to vendors and debtors. Feel free to contact a Banking law attorney with any questions.

This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.

Client alert authored by: Michael L. Moskowitz, Of Counsel and Melissa A. Guseynov, Of Counsel

This alert originally appeared in the Spring 2018 Banking Focus newsletter.

[1] The seller must also provide proper notice of reclamation.