Member Article

Vendors who sell goods to customers are probably familiar with the issues that arise when the customer later files bankruptcy. For instance, Section 546(c) of the Bankruptcy Code (and applicable state law) provides a vendor the right to reclaim goods it sold to the customer within 45 days of the bankruptcy petition date. In order for these “reclamation rights” to arise, the goods must have been: (i) sold in the ordinary course of the seller’s business; (ii) the debtor must have been insolvent when it received the goods; and (iii) the seller must serve a written demand to reclaim the goods within 45 days of the debtor receiving the goods, or within 20 days after the commencement of the bankruptcy case if the 45-day period expires after the commencement of the case.

In many cases, a vendor simply sends its reclamation demand attempting to preserve its rights and then waits until the debtor specifically addresses reclamation claims or deals with reclamation claimants through a plan of reorganization. A recent opinion from the United States District Court for the Eastern District of Virginia may cause vendors to revisit their strategy in enforcing these reclamation rights and to act more forcefully to preserve and assert their rights.

In Paramount Home Entertainment, Inc. v. Circuit City Stores, Inc.,¹ a copy of which can be viewed here, Paramount sought to reclaim approximately $11.6 million of goods it delivered to Circuit City within 45 days of the bankruptcy filing. In addition to serving a written demand, Paramount promptly filed a proof of claim in the same amount, asserting priority pursuant to Sections 546(c) and 507(a)(2) of the Bankruptcy Code. Circuit City opposed Paramount’s reclamation demand, claiming that it was precluded by procedures approved by the Bankruptcy Court early in the case that required the Debtors to advise reclamation claimants of the allowed amount, if any, of each claimant’s reclamation claim on or before March 10, 2009. Circuit City had not replied to Paramount’s reclamation demand, contending that Paramount’s reclamation demand was deemed rejected. Additionally, Circuit City objected to Paramount’s priority claim and sought to reclassify it as a general unsecured claim.

The Bankruptcy Court agreed with Circuit City, holding that Paramount waived its claim by failing to diligently pursue its reclamation demand. Noting that the right of reclamation is not self-executing, the Bankruptcy Court held that Paramount failed to take actions that a prudent seller would take to protect its reclamation rights, including filing a motion to lift the automatic stay or filing an adversary proceeding against the Debtors. The Bankruptcy Court also found that Paramount waived its rights by failing to object to the Debtors’ “going out of business” sales because, according to the Bankruptcy Court, reclamation rights are in rem, and Paramount had no basis for arguing that its reclamation rights attached to the proceeds from the sale of the reclamation goods to good faith purchasers for value. The Bankruptcy Court also pointed out that Paramount’s reclamation claim was primed at all times by the secured creditor’s pre-petition blanket lien, and more importantly, Paramount allowed the Debtors, without objection, to grant a blanket lien in connection with the post-petition DIP financing on all of the Debtors’ collateral, including Paramount’s reclamation goods.

On appeal, Paramount argued that it properly preserved its reclamation rights because it complied with the requirements of Section 546(c) of the Bankruptcy Code and the Bankruptcy Court’s reclamation order by serving its notice and filing a proof of claim. Paramount argued that forcing vendors to file motions to lift the automatic stay and/or file adversary proceedings would be taxing on debtors and the judicial system and is not required by the Bankruptcy Code. Paramount also argued that timely filing its proof of claim was evidence that it “actively pursued its reclamation demand.”

The District Court rejected Paramount’s arguments, holding that a reclamation claimant must “diligently assert its rights while bankruptcy proceedings progress. . .Filing a demand, but then doing little else in the end likely creates more litigation and pressure on the Bankruptcy Court than seeking relief from the automatic stay imposed by § 362 or seeking a TRO or initiating an adversary proceeding.” The District Court reasoned that while Paramount did timely file its reclamation demand, it failed to seek court intervention to perfect that right. The Court held that “although § 546 does not explicitly state that a reclaiming seller must seek judicial intervention, that statute does not exist in a vacuum,” and therefore, Paramount should have taken additional steps to protect its rights, such as objecting to the sale of its goods and/or seeking relief from the automatic stay. The District Court agreed that Paramount’s failure to object to either the going out of business sales or the use of its goods in connection with the post-petition financing amounted to a waiver of any right Paramount had to reclaim the goods.

The facts of the case may not apply to every situation, and it remains to be seen whether courts outside the Eastern District of Virginia will adopt this heightened standard for preserving reclamation rights. However, this opinion is noteworthy in demonstrating that courts are willing to hold reclamation claimants to a higher standard than simply proving that they timely served the debtor with a reclamation demand. Suppliers to distressed businesses must therefore take a proactive approach in monitoring bankruptcy cases for any filings that may affect their reclamation rights. In addition, depending on the costs and benefits of taking protective action, reclaiming creditors would be well-served in considering taking additional steps to enforce their reclamation rights, including objecting to the early efforts usually arising in a case to approve debtor in possession financing or the use of cash collateral. Similarly, more proactive steps might also be taken to seek to preserve the goods themselves, such as by seeking to lift the automatic stay to pursue the goods, or possibly commencing an adversary proceeding to prevent the debtor from using or selling the goods.

The costs and benefits of taking more direct action are often a function of how much the reclamation goods are valued, and also reviewing whether the goods can be easily identified or whether turnover of the goods may prove difficult. Similarly, the intervening rights of prepetition secured creditors can pose a hurdle as well.

The net impact of this ruling remains questionable since the procedures order in Circuit City did not seem to mandate any additional action by Paramount. The requirement imposed by the Bankruptcy Court and District Court that reclamation claimants file multiple pleadings to protect their claims will multiply litigation in the early stages of a bankruptcy case. Nonetheless, in circumstances where the stakes are substantial, suppliers should be aware of this precedent.

For more information, please contact any of the following lawyers.