Vendor's Reclamation Rights Survive Lien of Post-Petition DIP Loan

In Reichhold, the debtor was a borrower under a prepetition credit facility when it filed its Chapter 11 petition and had granted the prepetition lender a lien on substantially all of its assets, including its inventory. The bankruptcy court authorized the debtor to obtain post-petition DIP financing from a group of lenders, and to repay the prepetition loan in full from the proceeds of the DIP loan. The DIP loan was secured by a first-priority lien on all prepetition and post-petition property of the debtor, including all its inventory. The lien, however, did not attach to property that was subject to valid, perfected and nonavoidable liens or to valid liens in existence as of the petition date that were subsequently perfected as permitted by Section 546(b) of the Bankruptcy Code.

Within days of the petition, Covestro, LLC delivered a written reclamation demand to the debtor. Covestro later filed a reclamation claim seeking the value of goods delivered to the debtor between 21 and 45 days prior to the commencement of the bankruptcy case. The debtor filed a limited objection to the reclamation claim, arguing that the claim was rendered valueless when the prepetition loan was repaid.

The liquidating trustee for the debtor argued that the DIP lenders' rights, although granted after Covestro's reclamation rights arose, related back to the prepetition lender's rights because the DIP loan repaid the prepetition loan, and the two liens should be viewed as an “integrated transaction.”

Further, based on the theory that the goods were used to repay the prepetition lender, the trustee argued that Covestro's rights were extinguished when the debtor repaid the prepetition loan because reclamation permits a seller to reclaim only the goods themselves. The trustee's position was supported by several decisions from the Bankruptcy Court for the Southern District of New York, which held that where a prepetition secured lender had a floating lien on inventory and was paid from the proceeds of a post-petition loan supported by a new floating lien, the goods securing the prepetition lender's debt were effectively used to repay the loan and wiped out the vendor's intervening reclamation rights.

DIP Lenders's Rights

Covestro argued that its reclamation rights were not subject to the DIP lenders' rights because the DIP lenders' floating lien was distinct and separate from the prepetition lender's lien and arose after Covestro's rights arose. Its position was supported by a decision from the Bankruptcy Court for the Northern District of Ohio, In re Phar-Mor, 301 B.R. 482 (Bankr. N.D. Ohio, 2003), aff'd 534 F.3d 502 (6th Cir. 2008), which held that a post-petition lender's floating lien on the debtor's inventory did not constitute an assumption of the prepetition creditor's lien, but was an entirely new lien that did not defeat an intervening reclaiming seller's rights. In affirming the decision, the U.S. Court of Appeals for the Sixth Circuit expressly rejected the U.S. Court of Appeals for the Second Circuit cases.

Judge Walrath agreed with the decision in Phar-Mor. When the prepetition loan was paid from the DIP loan, the prepetition lender's lien was satisfied but Covestro's reclamation rights remained in force. The fact that funds from the DIP Loan were used to satisfy the prepetition loan, or that the debtor granted the DIP Lenders a lien on inventory to obtain such funds, was irrelevant, since Covestro's reclamation rights arose before the DIP Lenders' security interest attached, and the DIP lender's lien was expressly subject to reclamation rights under Section 546.

The judge also rejected the argument that the repayment of the prepetition loan from the DIP loan was repayment from the “sale” of the reclaiming creditor's goods. Covestro's goods were not sold and their proceeds were not paid to the prepetition lender. The latter was paid from the proceeds of the DIP loan, and the reclaimed goods were merely pledged to secure that loan.
Finally, the two loans did not constitute an “integrated transaction.” They were two different loans by two different lenders at two different times. Because Covestro's rights arose before the DIP lenders had any rights in the goods, the DIP lenders did not have prior rights in the goods under Section 546(c).

In this case, the order authorizing the DIP Loan expressly provided that the first-priority lien securing the DIP loan was “subject to valid, perfected and non-avoidable liens (or to valid liens in existence) as of the petition date that are subsequently perfected as permitted by Section 546 (b) of the Bankruptcy Code.” It is not clear whether the outcome in Reichhold would have been different had the DIP Loan provided otherwise or been silent regarding the status of the intervening reclamation lien. The primary rationale of the case, that the liens of the prepetition lender and the post-petition DIP lender were separate and distinct, and attached at different times, would suggest that the outcome ultimately did not depend on the language in the DIP loan regarding the scope of the first priority lien securing the loan. In rejecting the Second Circuit decisions, Judge Walrath breathed new life into vendors' state-law reclamation rights in bankruptcy.

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Barry M. Klayman is a member in the commercial litigation group and the bankruptcy, insolvency and restructuring practice group at Cozen O'Connor. He regularly appears in Chancery Court. Mark E. Felger is co-chair of the bankruptcy, insolvency and restructuring practice group at the firm. This article also appeared in the Delaware Business Court Insider, an ALM sibling publication of this newsletter.

In In re Reichhold Holdings US, Inc., Case No. 14-12237 (MFW) (Bankr. Del., Aug. 24), bankruptcy judge Mary F. Walrath upheld the validity of a vendor's administrative claim for its reclamation rights under Section 546(c) of the Bankruptcy Code as against a post-petition DIP lender. In doing so, Judge Walrath declined to follow cases from the Bankruptcy Court of the Southern District of New York that held otherwise.

Background

The Bankruptcy Code recognizes a vendor's right of reclamation for goods sold to a debtor if the seller has a right of reclamation under state law. A seller seeking reclamation under Section 2-702 of the UCC and Bankruptcy Code Section 546(c) must prove four elements: 1) The debtor was insolvent when the goods were delivered; 2) A written demand was made not later than 45 days after the debtor's receipt of the goods, nor later than 20 days following the petition date if the 45-day period expired post-petition; 3) The goods were identifiable at the time of the demand; and 4) The goods were in the possession of the debtor at the time of the demand.

In Reichhold, the debtor was a borrower under a prepetition credit facility when it filed its Chapter 11 petition and had granted the prepetition lender a lien on substantially all of its assets, including its inventory. The bankruptcy court authorized the debtor to obtain post-petition DIP financing from a group of lenders, and to repay the prepetition loan in full from the proceeds of the DIP loan. The DIP loan was secured by a first-priority lien on all prepetition and post-petition property of the debtor, including all its inventory. The lien, however, did not attach to property that was subject to valid, perfected and nonavoidable liens or to valid liens in existence as of the petition date that were subsequently perfected as permitted by Section 546(b) of the Bankruptcy Code.

Within days of the petition, Covestro, LLC delivered a written reclamation demand to the debtor. Covestro later filed a reclamation claim seeking the value of goods delivered to the debtor between 21 and 45 days prior to the commencement of the bankruptcy case. The debtor filed a limited objection to the reclamation claim, arguing that the claim was rendered valueless when the prepetition loan was repaid.

The liquidating trustee for the debtor argued that the DIP lenders' rights, although granted after Covestro's reclamation rights arose, related back to the prepetition lender's rights because the DIP loan repaid the prepetition loan, and the two liens should be viewed as an “integrated transaction.”

Further, based on the theory that the goods were used to repay the prepetition lender, the trustee argued that Covestro's rights were extinguished when the debtor repaid the prepetition loan because reclamation permits a seller to reclaim only the goods themselves. The trustee's position was supported by several decisions from the Bankruptcy Court for the Southern District of New York, which held that where a prepetition secured lender had a floating lien on inventory and was paid from the proceeds of a post-petition loan supported by a new floating lien, the goods securing the prepetition lender's debt were effectively used to repay the loan and wiped out the vendor's intervening reclamation rights.

DIP Lenders's Rights

Covestro argued that its reclamation rights were not subject to the DIP lenders' rights because the DIP lenders' floating lien was distinct and separate from the prepetition lender's lien and arose after Covestro's rights arose. Its position was supported by a decision from the Bankruptcy Court for the Northern District of Ohio, In re Phar-Mor, 301 B.R. 482 (Bankr. N.D. Ohio, 2003), aff'd 534 F.3d 502 (6th Cir. 2008), which held that a post-petition lender's floating lien on the debtor's inventory did not constitute an assumption of the prepetition creditor's lien, but was an entirely new lien that did not defeat an intervening reclaiming seller's rights. In affirming the decision, the U.S. Court of Appeals for the Sixth Circuit expressly rejected the U.S. Court of Appeals for the Second Circuit cases.

Judge Walrath agreed with the decision in Phar-Mor. When the prepetition loan was paid from the DIP loan, the prepetition lender's lien was satisfied but Covestro's reclamation rights remained in force. The fact that funds from the DIP Loan were used to satisfy the prepetition loan, or that the debtor granted the DIP Lenders a lien on inventory to obtain such funds, was irrelevant, since Covestro's reclamation rights arose before the DIP Lenders' security interest attached, and the DIP lender's lien was expressly subject to reclamation rights under Section 546.

The judge also rejected the argument that the repayment of the prepetition loan from the DIP loan was repayment from the “sale” of the reclaiming creditor's goods. Covestro's goods were not sold and their proceeds were not paid to the prepetition lender. The latter was paid from the proceeds of the DIP loan, and the reclaimed goods were merely pledged to secure that loan.
Finally, the two loans did not constitute an “integrated transaction.” They were two different loans by two different lenders at two different times. Because Covestro's rights arose before the DIP lenders had any rights in the goods, the DIP lenders did not have prior rights in the goods under Section 546(c).

In this case, the order authorizing the DIP Loan expressly provided that the first-priority lien securing the DIP loan was “subject to valid, perfected and non-avoidable liens (or to valid liens in existence) as of the petition date that are subsequently perfected as permitted by Section 546 (b) of the Bankruptcy Code.” It is not clear whether the outcome in Reichhold would have been different had the DIP Loan provided otherwise or been silent regarding the status of the intervening reclamation lien. The primary rationale of the case, that the liens of the prepetition lender and the post-petition DIP lender were separate and distinct, and attached at different times, would suggest that the outcome ultimately did not depend on the language in the DIP loan regarding the scope of the first priority lien securing the loan. In rejecting the Second Circuit decisions, Judge Walrath breathed new life into vendors' state-law reclamation rights in bankruptcy.

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Barry M. Klayman is a member in the commercial litigation group and the bankruptcy, insolvency and restructuring practice group at Cozen O'Connor. He regularly appears in Chancery Court. Mark E. Felger is co-chair of the bankruptcy, insolvency and restructuring practice group at the firm. This article also appeared in the Delaware Business Court Insider, an ALM sibling publication of this newsletter.