July 18, 2008

Sixth Circuit Agrees That a Vendor's Administrative-Expense Priority on its Reclamation Claim Survives After Sale of Goods Subject to Reclamation

On July 17, 2008, in Phar-Mor, Inc. v. McKesson Corp. (Nos 05-4525/4526), the Sixth Circuit affirmed the Northern District of Ohio's ruling that a vendor's administrative expense priority on its reclamation claim survives, even after the goods that are subject to reclamation are sold and the proceeds are used to satisfy a secured creditor's superior claim. Full text of the opinion.  

Facts

Phar-Mor, Inc. filed Chapter 11 bankruptcy on September 24, 2001.  In response, several vendors, including McKesson Corporation, filed timely “reclamation claims,” pursuant to 11 U.S.C. § 546(c) and Ohio Rev. Code § 1302.76 (UCC § 2-702), seeking to recover goods they had delivered to Phar-Mor on credit.

On October 5, 2001, Phar-Mor proposed “that each Vendor be granted an administrative expense priority claim under Section 503(b) in the amount (if any) of its allowed reclamation claim,” and reported reclamation claims from 141 vendors (including McKesson) totaling $18 million.

During the course of the bankruptcy case, the court authorized Phar-Mor to borrow up to $135 million to repay its pre-petition secured creditors.  Phar-Mor did so and the prior security interests were extinguished. Phar-Mor gave the new creditors (i.e., “DIP Lenders”) super-priority status over the remaining security interests, which also meant that their claims had priority over any administrative expense claims, such as McKesson’s.  With the proceeds of a number of liquidation sales, Phar-Mor was able to pay off the $135 million post-petition loan from the DIP Lenders. 

On February 13, 2003, Phar-Mor moved the bankruptcy court to reclassify the reclamation claims as general unsecured claims, arguing that the vendors’ administrative-expense priority was extinguished when the goods subject to reclamation were sold and the proceeds used to pay off the DIP Lenders.  The bankruptcy court denied the motion and held that, even though the reclamation claims were rendered “subject to” the DIP Lenders’ super-priority, the vendors’ properly filed reclamation claims still had administrative-expense priority over the general claims.  Phar-Mor appealed to the district court, which affirmed the bankruptcy court.

Analysis  

The applicable version of 11 U.S.C. § 546(c)(2) provides:

[T]he rights and powers of a trustee . . . are subject to any statutory or common-law right of a seller of goods that has sold goods to the debtor, in the ordinary course of such seller’s business, to reclaim such goods if the debtor has received such goods while insolvent, but — . . . the court may deny reclamation to a seller with such a right of reclamation that has made such a demand only if the court —

(A) grants the claim of such a seller priority as a claim of a kind specified in section 503(b) of this title [i.e., an administrative expense]; or

(B) secures such claim by a lien.

See 11 U.S.C. § 546(c)(2) (1998) (amended in 2005 by Pub. L. 109-8, § 1227(a)).

It was undisputed that McKesson sold goods to Phar-Mor in the ordinary course of its business, that Phar-Mor received the goods while insolvent, and that McKesson, upon discovering Phar-Mor’s insolvency, made a timely, written demand for reclamation.  Thus, the question before the court was whether McKesson had a statutory or common-law right, pursuant to Ohio law, to reclaim those goods.

The Ohio statute provides an aggrieved seller with a right to reclaim its goods as set forth in Ohio Rev. Code § 1302.76(B). This provision states "[w]here the seller discovers that the buyer has received goods on credit while insolvent he may reclaim the goods upon demand made within ten days after the receipt, but if misrepresentation of solvency has been made to the particular seller in writing within three months before delivery the ten day limitation does not apply."  Ohio Rev. Code § 1302.76(B).

Construing Ohio law, the Sixth Circuit held that Ohio Rev. Code § 1302.76(B) (UCC 2-207(2)) grants a properly reclaiming vendor, such as McKesson, a right to reclaim its goods and that § 1302.76(C) (UCC 2-207(3)) does not allow a secured creditor’s claim to defeat that right. Although the Court recognized that 11 U.S.C. § 546(c)(2) grants the bankruptcy court the power to deny a properly reclaiming vendor its right to reclaim the goods, the Code requires that the denied vendor be granted either an administrative-expense priority in the amount of the goods or a lien on the proceeds resulting from the use of those goods by the debtor.

This E-alert was prepared by Justin W. Ristau. Please contact any member of the Bricker & Eckler Creditor Rights & Bankruptcy group for more information.