Everybody knows that the dice are loaded: reclamation rights are illusory in bankruptcy cases. Where a supplier ships goods to a company that later files for bankruptcy, section 546(c) of the Bankruptcy Code provides reclamation remedies (i.e., supplier getting the goods back) under certain circumstances (there are time limits, etc.) if the supplier has such rights under state law (e.g., Uniform Commercial Code section 2-702).
But most corporate debtors have a secured creditor in place with liens on all property of the debtor, including inventory and proceeds thereof. And most states have laws in place that subject a reclamation claim to the rights of a buyer in the ordinary course of business or other good faith purchaser. Everybody knows that the secured creditor with a blanket lien smothers the reclamation rights of the supplier. And that this continues to be so when a post-petition DIP Loan is established in the bankruptcy case (for more about DIP loans, see here).
And then along comes In re Reichhold Holdings US, Inc., Case No. 14-12237 (Bankr. D.Del. Aug. 24, 2016), see opinion here, to tell us that everybody’s wrong this time.
The debtor Reichhold supplied to the composite and coatings industry, and the creditor-supplier Covestro (formerly Bayer’s materials science division, since spun off) supplies coatings, adhesives, and polyurethanes. Wiki tells us that Covestro polyurethanes were used in the 2014 official FIFA World Cup soccer ball.
Debtor filed its chapter 11 bankruptcy petition. Supplier wanted its materials back or, failing that, an administrative expense claim in the dollar amount of the materials supplied to Debtor for which supplier had not been paid. An administrative expense claim is good for a creditor, for a plan of reorganization cannot be confirmed unless it proposes to pay administrative expense claims in full before unsecured claimants receive anything.
Covestro filed its reclamation demand, and later a proof of claim asserting the amount to be reclaimed as an administrative expense claim. A liquidating plan was confirmed, resulting in the creation of a liquidating trust. The liquidating trustee generally has a duty to object to allowance and payment of plausibly invalid administrative claims, so as to raise the return for unsecured creditors.
The liquidating trustee objected, arguing that Covestro’s administrative expense claim was rendered valueless when the pre-petition secured loan was repaid by the post-petition DIP Loan. In the pre-petition secured loan and the post-petition DIP Loan, the Debtor had granted each lender a lien on substantially all of Debtor’s assets, including inventory.
The pre-petition lender was Oaktree Capital Management, L.P. Oaktree was not the DIP lender (which was a group we will call the DIP Lenders). The order approving the DIP Loan authorized the DIP Lenders to repay Oaktree from proceeds of the DIP Loan. Of some importance: the order provided that the DIP Loan’s first priority lien 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).”
Under section 546(c) of the Bankruptcy Code, if a claimant can prove that it has a valid reclamation right under state law (UCC 2-702), great, but such right is nevertheless “subject to the prior rights of a holder of a security interest in such goods or the proceeds thereof.” Covestro established its rights under UCC 2-702. The liquidating trustee argued that Covestro’s reclamation rights were subject to the rights of Oaktree, and that the later-in-time DIP Lender’s rights related back to Oaktree’s because the DIP Loan repaid the Oaktree loan. The liquidating trustee argued that the two liens should be viewed as an “integrated transaction.” Covestro rejoined that the DIP lenders’ liens are separate from those of Oaktree and arose after Covestro’s reclamation rights and are thus junior those rights.
In ruling for Covestro, the Reichhold court notes that the liquidating trustee has on its side well-known opinions of the United States Bankruptcy Court for the Southern District of New York in In re Dana Corp., 367 B.R. 409, 420 (Bankr. S.D.N.Y 2007) and In re Dairy Mart Convenience Stores, Inc., 302 B.R. 128 (Bankr. S.D.N.Y. 2003), which held that “where a pre-petition lender had a floating lien on inventory and was paid from the proceeds of post-petition loan supported by a new floating lien, the goods securing the pre-petition lender’s debt were effectively used to repay that debt.” Following this formulation, the goods having been used up, there would be nothing left to be reclaimed. What’s more, for the New York courts, the two loans were part of an “integrated transaction.”
The Reichhold court disagrees with the applied abstractions of “integrated transaction” and of repayment of the pre-petition loan meaning that all the goods securing that loan have been used up. The court’s reasoning is direct and palpable: when a loan is paid, that loan’s lien is satisfied (however that is done does not matter), but the supplier’s reclamation rights remain in force. The supplier’s reclamation rights arose before the DIP lenders’ security interest attached; and in addition the DIP lenders’ lien was expressly subject to reclamation rights under section 546. Continuing in its straightforward vein, the court stated, “In fact, Covestro’s goods were not sold and their proceeds were not paid to [Oaktree].” Thus, concluded the court, the DIP lenders do not have prior rights in the goods under section 546(c).
Which reminds me of the Lincoln witticism, though Snopes denies Lincoln said it, that even if you decide to count a dog’s tail as a leg, a dog still has only four legs. See 11 U.S.C. 1129(a)(9).  In re Reichhold Holdings US, Inc., Case No. 14-12237 (Bankr. D.Del. Aug. 24, 2016) at 2.  In re Reichhold Holdings US, Inc., Case No. 14-12237 (Bankr. D.Del. Aug. 24, 2016) at 6.  See id. at 6-7  Id. at 8.  Id. at 6 (emphasis sic).
Mr. Cahill is a partner at L&G Law Group LLP, in Chicago, Illinois. In addition to a wide variety of corporate work, including with respect to digital assets, he guides secured lenders, creditors, debtors, creditors’ committees, potential purchasers and others through bankruptcy cases, out-of-court workouts, assignments for the benefit of creditors, and receiverships. Mr. Cahill…
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