• Recent Bankruptcy Court Rulings Significantly Impact Supply Chain Issues
  • August 15, 2017 | Authors: Peter J. Keane; Bradford J. Sandler
  • Law Firms: Pachulski Stang Ziehl & Jones LLP - Wilmington Office; Pachulski Stang Ziehl & Jones LLP - New York Office
    • Third Circuit Holds That, for Purposes of Section 503(b)(9), Requirement of Determining “Goods Received” Means Actual Physical Possession by a Debtor or its Agent.
    • Delaware Bankruptcy Court Rules That a Vendor Directly Shipping Goods to a Debtor’s Customers Does Not Have a 503(b)(9) Claim.

    The Third Circuit Gives Some Relief to Vendors

    Vendors that ship goods to companies in distress are entitled to administrative expense status for the value of goods “received by the debtor within 20 days before” the debtor’s bankruptcy filing under section 503(b)(9) of the Bankruptcy Code. [1] Last week, the Third Circuit issued a decision in In re World Imports, Ltd. [2], holding that the word “received” in section 503(b)(9) requires actual physical possession of the goods by a debtor or its agent in order for a vendor’s claim to achieve administrative expense status. This decision has important implications. Business is increasingly conducted on a global scale, and delivery arrangements frequently are made through common carriers, which can lead to delayed shipment times. Typically, a chapter 11 debtor seeking to limit the amount of administrative claims generated by section 503(b)(9) will argue that it constructively received goods when the vendor delivered the goods to the debtor’s common carrier in an effort to push back the receipt date so that it extends falls prior to beyond the 20-day window under section 503(b)(9). Now, vendors whose customers file for bankruptcy in the Third Circuit will have a greater likelihood that goods they ship, all other things equal, will fall within the 20-day window of section 503(b)(9), thereby generating administrative expense status for their claim and substantially increasing the likelihood of payment.

    Haining Wansheng Sofa Company and Fujian Zhangzhou Foreign Trade Company are Chinese companies that sold furniture and similar goods to World Imports (the debtor) in the ordinary course of business. Those goods were shipped via common carrier from China to the United States “free on board” (FOB) at the port of origin, so the risk of loss or damage passed to World Imports upon transfer at the port. The Haining shipment left Shanghai, China on May 26, 2013, and World Imports took physical possession of the goods in the United States on June 21, 2013. Fujian's goods were shipped on three separate dates from Xiamen, China on May 17, May 31, and June 7, 2013, and they were accepted in the United States within 20 days of July 3, 2013, the day on which World Imports filed its chapter 11 petition. Both Haining and Fujian filed motions for allowance and payment of administrative expense under section 503(b)(9).

    Under section 503(b)(9) of the Bankruptcy Code, the value of goods received by a debtor are entitled to administrative priority status, rather than general unsecured status, if (1) the vendor sold goods to the debtor, (2) the goods were received by the debtor within twenty days before the bankruptcy filing, and (3) the goods were sold in the ordinary course of business. A claim entitled to administrative priority status has a much greater likelihood of being paid in full compared to a general unsecured claim.

    The word “received” in section 503(b)(9) is not defined in the Bankruptcy Code and the bankruptcy court in World Imports rejected using the Uniform Commercial Code (UCC) definition, which defines “receipt” of goods as “taking physical possession of them.” [3] Instead, the bankruptcy court looked to the Convention on Contracts for the International Sale of Goods (CISG)—which it found governed disputes arising between the debtor and creditors—as a treaty that preempts the UCC. The bankruptcy court looked to the international commercial terms incorporated into the CISG, which, for FOB contracts, make clear that the risk of loss transfers at the port when the seller delivers the goods to the common carrier’s vessel. So the bankruptcy court concluded the goods were “constructively received” when shipped from China, and it denied the motions by Haining and Fujian. The district court affirmed that decision.

    On appeal, the Third Circuit rejected the debtor’s arguments that the goods were “constructively received” at the port, and it held that there was no support for the idea that a buyer constructively receives goods when they are delivered to a common carrier, even if title and risk of loss pass at that time. In other words, regardless of FOB status, under the UCC and chapter 11, the Third Circuit held that receipt does not occur until after the seller's ability to stop delivery ends—namely, upon the physical possession by the buyer or its agent—and a common carrier is not the buyer’s agent. Transfer of risk is not the same thing as receipt. In addition, the Third Circuit held that the ordinary Black’s Law Dictionarymeaning of “received” is physical possession. Moreover, the UCC governed the sale of goods in 49 states when section 503(b)(9) was adopted, so the court inferred that Congress meant to adopt the well-known meaning of the word “received” that the UCC uses. Finally, section 503(b)(9) was added by Congress in 2005 as an exemption to the general bankruptcy reclamation scheme established by section 546(c). Back in 1984, the Third Circuit in In re Marin Motor Oil, interpreted that original provision of section 546(c) in order to resolve the question of whether UCC § 2-702(2) (allowing reclamation) applies where the debtor files for bankruptcy. In Marin Motor, the Third Circuit held that because Congress essentially borrowed the reclamation provision from the UCC, it also borrowed the standard definition of receipt, which occurs when the buyer takes physical possession of the goods. [4] Given the interrelationship between section 546(c) and 503(b)(9) provisions and the Marin Motor holding that Congress meant for terms used in section 546(c) to bear the definition used in the UCC, the Third Circuit reasoned, the UCC definitions also should apply to section 503(b)(9) exception. Because World Imports took possession within the 20-day period before commencement of its bankruptcy case, the Third Circuit reversed the decisions of the district court and bankruptcy court and remanded.

    Aftermath: World Import Used as a Sword Against Vendors

    Within several days of the Third Circuit’s ruling in World Imports, a Delaware bankruptcy court applied the World Imports ruling with potentially devastating consequences in In re SRC Liquidation, LLC. [5] In SRC, the court relying on World Imports held that goods delivered to a common carrier for shipment to a debtor’s customer during the 20 days before the debtor’s bankruptcy filing are not entitled to section 503(b)(9) claim status. However, in SRC, the vendor delivered the goods to the debtor’s common carrier for direct shipment to the debtor’s customer. The Delaware bankruptcy court held that since the debtor never physically possessed the goods, only the common carrier did, and the common carrier did not qualify as an agent of the debtor, the vendor was not entitled to a 503(b)(9) claim. Essentially, the court’s ruling created a bright line rule that any direct ship vendor would not be entitled to a section 503(b)(9) claim.

    Conclusion

    It is critical for vendors and debtors to understand the mechanics of their supply chainbecause it can impact the amount or allowability of a vendor’s 503(b)(9) claim. While the SRC holding arguably deals a devastating blow to direct ship vendors, the Third Circuit ruling in World Imports will help suppliers obtain an administrative priority claim under section 503(b)(9) of the Bankruptcy Code by holding that “goods received” means that a debtor or its agent must have actual physical possession, and not constructive possession, of goods. This ruling may benefit commerce because a seller of goods may be more inclined to permit the shipment of its goods to a distressed customer knowing that it will be entitled to an administrative claim if the customer files for bankruptcy in a court within the Third Circuit’s jurisdiction (i.e., Pennsylvania, New Jersey, Delaware, and the Virgin Islands). Additionally, the distressed customer may find it easier to procure goods because sellers of goods may be willing to rely on the World Imports holding that would increase the likelihood of the seller getting paid for its 503(b)(9) claim should the customer file for bankruptcy.

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    [1] Under Bankruptcy Code section 503(b)(9), a creditor may recover as a priority administrative expense the value of goods “received by the debtor within 20 days before” the bankruptcy petition is filed. 11 U.S.C. § 503(b)(9).

    [2] In re World Imports, Ltd., No. 16-1357, 2017 U.S. App. LEXIS 12254, (3d Cir. July 10, 2017).

    [3] UCC § 2-103(1)(c).

    [4] 740 F.2d 220, 224-25 (3d Cir. 1984).

    [5] In re SRC Liquidation, LLC, Case No. 15-10541, 2017 Bankr. LEXIS 1932 (Bankr D. Del. July 13, 2017).