Sears Chapter 11 Rulings Threaten to Upend Administrative Claim Status for Goods Vendors

Application of Section 503(b)(1)(A) and 503(b)(9) in the Sears Chapter 11 Filing

Precedent setting rulings in the Sears chapter 11 case could radically alter how vendors support companies who file for bankruptcy in the future. Historically the presumption and practice in the vast majority of bankruptcy cases has been that vendors receive priority status for goods delivered beginning not only 20 days prior to the filing, but also continuing after the filing. Bankruptcy code Section 503(b)(9) applies to goods delivered prior to the petition, and Section 503(b)(1)(A) applies afterwards. Because both call for essentially the same type of priority claim, the distinction between these two sections has not been particularly relevant until now.

Early on in the Sears case, it became apparent that the Debtor was going to take a different view of both code Sections than historical norms. The Debtor’s view would decrease its administrative claim burden by over $63 million and consequently convert those vendor claims to general unsecured (which are not expected to receive any recovery). This impact was felt most acutely by foreign vendors whose goods have long shipping lead times.

Post-Petition Admin: 503(b)(1)(A)

The historical norm has been that goods delivered to Debtors after the petition date qualified for administrative priority under 503(b)(1)(A) “[a]fter notice and a hearing, there shall be allowed administrative expenses,” including “the actual, necessary costs and expenses of preserving the estate.” We assume Congress’ intention was that vendors who continue to support debtors deserve to be rewarded with priority status. For vendors, this usually meant that if goods were in transit on the petition date, they would qualify for 503(b)(1)(A) when they arrived. This was supported by a vendor “comfort letter” issued by Sears, which seemed to echo this concept.

However, when vendors actually requested the priority status, the Debtor took a more nuanced view, which was supported by Judge Robert Drain in the Southern District of New York in the fall of 2019. Essentially, the Debtors argued that 503(b)(1)(A) requires a post-petition contract or relationship and goods, which were in transit on the petition date result from pre-petition dealings, and therefore, do not qualify for priority status.

The ruling made it essentially impossible for vendors to have any valid 503(b)(1)(A) claims, because it would require them to initiate a new post-petition contract for goods shipped post-petition. This creates what some vendors call an absurd result: it could encourage them to call back shipments that are in transit on the petition date if they are concerned about payment for unsecured claims. Judge Drain’s ruling is being appealed by at least one creditor who has the resources to oppose it.

20 Day Goods: 503(b)(9)

The historical norm has been that goods delivered to Debtors in the 20 days leading up to the petition date qualified for administrative priority under 503(b)(9). However, when vendors actually requested the priority status, the Debtor took a different view, one that was seen by many as contrary to the Third Circuit’s ruling in World Imports. Essentially the Debtors argued that 503(b)(9) does not define receipt and for foreign vendors delivering goods to shippers “free on board” or FOB, title and risk of loss transfers to the shipper on that date. Therefore, the Debtor receives the goods at the time the vendor hands them to its shipper (presumably overseas). These positions are currently the subject of contested hearings.

Sears Triple Whammy

In addition to the positions discussed above, which would reduce the total volume of administrative priority claims, several other developments in the Sears chapter 11 case have negatively impacted vendor recoveries.

First, the agreement for Transform Holdco (Edward Lampert’s vehicle that acquired the old Sears assets) to assume $170 million of vendor administrative claims was recently resolved for only $18 million. As a result of litigation and purchase price adjustments, the Debtor made the decision to settle the matter rather than litigate to a judgment of uncertain collectability.

Second, vendors with administrative claims were given the option to “opt-in” to a settlement that would pay them an initial cash distribution of $20 million on their claims in exchange for capping their face amount at 75%. The initial distribution was estimated at between 20 and 30%.

Third, Sears initiated hundreds of preference actions that seek to claw back funds paid to over 2,000 vendors in the 90 days leading up to the filing.

Conclusion

The Sears chapter 11 case contains important lessons for vendors, particularly those who supply goods from overseas with long lead times. It is critical to understand the latest interpretations of key bankruptcy code sections governing administrative claims. In some cases, affirmative actions can be taken, including calling back shipments or making sure to enter into new contracts post-petition. Having competent counsel involved is also a prudent step. In proceedings like Sears, which is teetering on administrative insolvency, these nuances can mean the difference between some recovery or nothing at all.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Focus on Retail and The Nuts & Bolts of a Chapter 11 Plan.]