Bankruptcy KEEP ACCURATE AND ORGANIZED RECORDS OF ANY TRANSACTIONS WITH A STRUGGLING CUSTOMER FILE A TIMELY PROOF OF CLAIM 2 OCTOBER 2005

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1 OCTOBER 2005 Bankruptcy Tips for Non-Bankruptcy Lawyers and Credit Managers on Defending Against Preference Claims and Asserting Reclamation Rights, or When You Forgot to Shut Off the Extension of Credit, What Next? This K&LNG Alert provides practical tips and information to credit managers and commercial lawyers who seek to reduce their employers risks from preference actions and to enhance their employers prospects of repossessing goods delivered to insolvent buyers or improving their employers status for recovery from the estates of bankrupt customers. Section I outlines some of the actions creditors may consider or take in order to avoid returning alleged preference payments. Section II describes the right of reclamation of goods sold or shipped to an insolvent or bankrupt customer and the requirements to repossess such goods or to obtain administrative expense priority or other adequate protection in connection with the insolvency or bankruptcy of a customer. TIPS FOR PREVENTING AND DEFENDING PREFERENCE ACTIONS Innocent creditors often receive demands to return payments from a bankrupt customer because the payment was made within 90 days of the customer s bankruptcy filing. A creditor must understand how to prevent or reduce the risk of liability for a preference claim and to defend against a preference action to recover such payments. 1 KEEP ACCURATE AND ORGANIZED RECORDS OF ANY TRANSACTIONS WITH A STRUGGLING CUSTOMER Keeping accurate records promotes efficiency and saves a creditor time and money if its customer files for bankruptcy and subsequently brings a preference action against the creditor. A creditor s attorneys will be better suited to facilitate a quick and favorable outcome if they do not have to spend hours going through the creditor s files. FILE A TIMELY PROOF OF CLAIM 2 A creditor should file a timely proof of claim to ensure that it will participate in the distribution of the bankruptcy estate. 3 The proof of claim should set forth the amount that the creditor is owed, the nature of the claim, and a description of how the amounts claimed were calculated. A proof of claim also provides valuable evidence of the creditor s new value defense. 4 Sometimes a creditor need not file a proof of claim when the debtor lists the amount it owes in its schedules and does not identify the amount as being unliquidated, contingent or disputed. The credit manager should consult legal counsel on whether a proof of claim needs to be filed in a particular case. It is very important that the claim be filed timely or it may be barred without any collection of a distribution being possible U.S.C. 547(b)(4)(A) (2000). 2 Credit managers should consult with legal counsel prior to filing proofs of claim because filing a proof of claim results in submission to the bankruptcy court s jurisdiction as to the merits of other disputes between the creditor and debtor and acts as a waiver of the right to jury trial. 3 Id. 101(5), 501(a). 4 See infra Part VII B. Kirkpatrick & Lockhart Nicholson Graham LLP

2 INVESTIGATE OTHER SETTLEMENTS OF PREFERENCE ACTIONS BY THE DEBTOR Creditors should have their bankruptcy counsel locate and examine any other preference settlements involving the debtor that a bankruptcy court has approved. This information should give the creditor an idea of what type of settlement offer the debtor might be willing to accept. WRITE A DETAILED AND DEFENSIVE SETTLEMENT LETTER THAT EXPLAINS WHY THE CUSTOMER S PREFERENCE ACTION WILL FAIL AT TRIAL One of the best ways to convince the debtor to settle a preference action is to write a detailed settlement letter after collecting the facts and researching the law in the jurisdiction where the case is pending. If the initial settlement letter contains a compelling list of reasons why the creditor will be able to avoid returning the so-called preference payments, the debtor s counsel will be more likely to drop the action or to settle the claim for a nominal amount. A settlement letter should resemble a legal brief capable of being presented to a court, thereby signaling to the debtor that the creditor will not be taken advantage of and is prepared to litigate. A letter signed by counsel reinforces the creditor s preparedness to defend against the claim vigorously. Sending this signal is crucial in helping a creditor obtain a favorable settlement. RAISE A STATUTE OF LIMITATIONS DEFENSE IN ANY INITIAL PLEADING IF APPROPRIATE A creditor should determine whether a statute of limitations defense is applicable, and if it is, the creditor must raise it in its initial pleading, or it will be waived. Trustees and debtors in possession must bring all preference actions within the time established by the applicable statute of limitations. If the party bringing the action is a debtor in possession (in other words, a debtor who is still operating the business), the applicable statute of limitations period ends two years after the entry on the docket of the bankruptcy court of the order for relief for the debtor that filed for bankruptcy. 5 However, if a trustee is appointed to manage the debtor s bankruptcy estate, the limitations period might be extended by one year if the appointment has occurred within the original two years following the filing. 6 MAKE THE PLAINTIFF PROVE EACH ELEMENT OF ITS CASE When considering how to defend against a preference action, a creditor should first determine whether the trustee or debtor in possession will be able to prove that a valid preference claim exists. If the creditor can point out a fatal omission in the debtor s or trustee s claim, there is a chance that the trustee or debtor will drop the case completely before he or it incurs significant legal costs in the matter. The debtor must prove the existence of six distinct elements before a payment will be deemed a preferential transfer under the Bankruptcy Code. The six elements of a preference action are a transfer: of capital a debtor s property or interest in property; To or for the benefit of a creditor; On account of an antecedent debt; Made while the debtor was insolvent; Made within 90 days (one year for insiders) of the filing of the bankruptcy petition; and That enables the creditor to receive more than it would have received in a Chapter 7 liquidation of the debtor. 7 The Transfer Must Be the Debtor s Property Although the most common transfer is a payment made by the debtor to the creditor, many types of transactions will be considered transfers. The Bankruptcy Code broadly defines a transfer as including the creation of a lien, the retention of title as a security interest, the foreclosure of a debtor s equity of redemption, or each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with (i) property; or (ii) an interest in property U.S.C. 546(a)(1)(A) (2000). 6 Id. 546(a)(1)(B). 7 Id. 547(b) U.S.C. 101(54) (effective October 17, 2005). All references to the Bankruptcy Code that are effective October 17, 2005 are amendments made pursuant to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No , sec (6), 119 Stat. 23, 193 (2005). 2 OCTOBER 2005 KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP

3 While it is not difficult for a debtor to show that there was a transfer, it is more difficult to prove that the transfer was of the debtor s property or of an interest in the debtor s property. If a creditor received a transfer from a third party, a creditor should perform a preliminary search of the facts underlying the transaction. If a payment is made by a third party not using the debtor s funds, then the payment is not a preferential transfer because there was not a transfer of property of the debtor or interest in the property of the debtor. The Transfer Must Be to or for the Benefit of the Creditor In order for a transfer to be to or for the benefit of a creditor, the debtor must prove that the transferee is a creditor. Section 101(10) of the Bankruptcy Code broadly defines a creditor as an: entity that has a claim against the debtor that arose at the time of or before the order for relief concerning the debtor; entity that has a claim against the estate [that arises after the order for relief but before conversion, in the ordinary course of the debtor s business after the commencement but before the appointment of a trustee, from the rejection of an executory contract or unexpired lease, from the recovery of property by the debtor, or after the commencement of the case for a tax]; or entity that has an immunity claim. 9 Claim is also broadly defined to mean a: right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured or unsecured; or right to an equitable remedy for breach of performance if such breach gives rise to a right to payment, whether or not such right to an equitable remedy is reduced to judgment, fixed, contingent, matured, unmatured, disputed, undisputed, secured, or unsecured. 10 When the transferee is not a creditor, or does not receive the transfer for the benefit of a creditor, the transfer is not a preferential transfer under 547 of the Bankruptcy Code. The Transfer Must Be on Account of an Antecedent Debt A debtor can only avoid payments made for an antecedent debt. 11 A debt is antecedent if it was incurred before the transfer. 12 However, a debt does not have to be overdue to be considered antecedent debt. Unlike some of the other elements of the trustee s prima facie case, a creditor can alter its own practices with a struggling customer to block a future trustee s attempt to collect the payment. Make the customer pay cash or wire transfer funds before delivery of the goods. 13 By requiring a customer to pay for goods before delivery, a creditor will ensure that the customer cannot avoid the payment if it later files for bankruptcy. A cash payment in advance of delivery is not for an antecedent debt. Thus, by altering its practices to require struggling customers to pay for goods before they are delivered, a creditor prevents the debtor from avoiding the transaction. A creditor requiring cash in advance of delivery of goods must make sure that the payment is properly applied. Applying the payment to past due balances creates the risk of avoidance of the payment as a preferential transfer. The Transfer Must Have Occurred While the Debtor was Insolvent A debtor is insolvent if the value of all its debts exceeds the fair value of all of its property, excluding fraudulently transferred property or exempt property of an individual. 14 Except in the most unusual circumstances, it is unlikely that a debtor was solvent in the few months leading up to the bankruptcy filing. Congress itself affirmed this position in the Bankruptcy Code. The Code states, the debtor is presumed to have been insolvent on and during the 90 days immediately preceding the date of the filing of the petition U.S.C. 101(10) (2000). 10 Id. 101(5). 11 Id. 547(b)(2). 12 Southmark Corp. v. Marley (In re Southmark Corp.), 62 F.3d 104, 106 (5th Cir. 1995). 13 In general, prior to bankruptcy, a pre-petition claim by seller may be setoff by a pre-petition claim of buyer. 11 U.S.C. 553 (2005) U.S.C. 101(32) (2000). 15 Id. 547(f). 3 OCTOBER 2005 KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP

4 Unless insolvency is a material issue, there typically is not much incentive for a creditor to attempt to rebut the presumption of insolvency because it is expensive to prove that a debtor was solvent at the time of the transaction. Even though it may be difficult to rebut the presumption of insolvency, the creditor can still use this element to gain leverage when attempting to settle the case. A creditor should examine the debtor s bankruptcy schedules to determine if the debtor ever made a representation that its assets exceeded its liabilities. Another way to rebut the presumption of insolvency is to examine whether the debtor ever claimed that it was solvent in reclamation cases in the early stages of the bankruptcy proceedings. 16 Although proving at trial that the debtor was solvent may be more costly than it is worth, the creditor can still assert that it will be able to prove solvency during the negotiations if it has evidence sufficient to rebut the presumption of insolvency. The Transfer Must Occur Within the Preference Period A creditor should not rely on the debtor s representation that the transfer occurred within the applicable preference period (90 days generally or one year if the transaction is with an insider 17 ), because the debtor may be incorrect. 18 By keeping accurate records, a creditor can prevent a debtor from misrepresenting either intentionally or mistakenly the date of the transfer. If the accurate transfer date falls outside of the appropriate preference period, the creditor can completely defend against the preference litigation with respect to that transfer. Cash customers checks as soon as possible. Creditors should cash checks received as soon as possible. The Supreme Court of the United States has said that when payment is made by check, the transfer will be deemed to have occurred on the date the check is honored by the debtor s bank. 19 If a creditor receives a check before the preference period but the check does not clear the debtor s bank until after the preference period begins, the payment may be avoidable as a preference. The Creditor Must Receive More Than It Would Receive in a Chapter 7 Liquidation Finally, a debtor or trustee must prove that the creditor received more from the transfer than it would have received under a Chapter 7 liquidation of the debtor s assets. This element of a preference action focuses on what is known as the 100 Percent Rule. 20 Under the 100 Percent Rule, the creditor who receives an allegedly preferential transfer is deemed to have received the full value 100 percent of the debt. Unless all creditors would have received full payments in a hypothetical Chapter 7 liquidation, the transfer might be subject to a valid preference claim. In addition, the debtor must also prove that the value of the estate declined as a result of the transfer. 21 A transfer can be recovered as a preference only if it involves the transfer of money or other assets of the debtor to the creditor so that the assets of the debtor are diminished. Even if a debtor proves the existence of a preferential transfer as a result of establishing the six elements discussed above, the creditor can prevail if it can show that it is entitled to one or more of the statutory exceptions or defenses to preference actions. A CREDITOR SHOULD RAISE ALL POSSIBLE AFFIRMATIVE DEFENSES IN ITS INITIAL PLEADING The general rule is that the statutory defenses established in 11 U.S.C. 547(b) are affirmative defenses, and therefore must be included in an answer to avoid being waived. 22 While the bankruptcy court has discretion to excuse a party s failure to raise an affirmative defense in an answer, creditors should not rely on their potential ability to persuade a judge to allow a defense not initially pled See Section II for details regarding reclamation U.S.C. 101(31) (2000). 18 Id. 547(b)(4). 19 See Barnhill v. Johnson, 503 U.S. 393 (1992). 20 Precision Walls, Inc. v. Crampton, 196 B.R. 299, 303 (E.D.N.C. 1996). 21 Fox v. Smoker (In re Noblit), 72 F.3d 757, 758 (9th Cir. 1995). 22 Fed. R. Civ. P. 8(c); see also Marshack v. Orange Commercial Credit (In re Nat l Lumber and Supply, Inc.), 184 B.R. 74, 78 (B.A.P. 9th Cir. 1995). 23 Marshack, 184 B.R. at OCTOBER 2005 KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP

5 The Contemporaneous Exchange for New Value Defense If a creditor can prove that a transfer was part of a contemporaneous exchange for new value, the trustee will not be able to avoid the transfer. To be protected by this exception, the creditor must show that: It extended new value to the debtor; Both parties intended the new value and the corresponding transfer by the debtor to be contemporaneous; and The exchange was indeed substantially contemporaneous. 24 Require the customer to acknowledge in writing that all reciprocal transfers will be considered contemporaneous. The most important factor in successfully asserting the defense is that both parties intended the exchange to be contemporaneous. A transfer by the creditor to the debtor on the same day that the debtor transfers value to the creditor will not fall under this exception unless both of the parties intended for the transaction to be contemporaneous. Because of this required formality, a creditor should explicitly inform its customers that all reciprocal transfers between the parties are considered contemporaneous. Securing this acknowledgment in writing may prove very beneficial to the creditor. Even if the creditor and debtor had intended an exchange to be contemporaneous, the creditor cannot successfully use the defense unless it proves that the transfers were contemporaneous from an objective perspective. Instead of providing a rigid definition for substantially contemporaneous, the Congress left the task of determining whether an exchange was substantially contemporaneous to the judiciary. 25 This vagueness in the statute allows creditors to argue that a debt created one day and repaid five days later is a contemporaneous exchange for new value; however, it also creates a factual inquiry that often will not be resolved until trial or will be a basis for settlement because of the uncertainty of proof. The Subsequent New Value Defense The subsequent new value defense is usually the easiest and best defense for a creditor to prove. This defense typically allows a creditor to avoid trial to the extent of the new value. In order to assert a new value defense, a creditor must prove that: After receiving an alleged preferential transfer, the creditor gave new value to or for the benefit of the debtor on an unsecured basis; and The debtor did not make an otherwise unavoidable transfer to the creditor on account of such new value. 26 Transfers of subsequent new value are not subject to preference claims because new value will offset payments previously made. As a result, the bankruptcy estate is not depleted. Although subsequent new value is an attractive defense because it is relatively easy to prove, this defense only protects transfers to the extent that new value was transferred and to the extent that the creditor does not receive subsequent payment. The following actions will increase a creditor s chance of successfully asserting the subsequent new value defense: Do not ship goods or provide services to a struggling customer on credit in response to the customer s promise to make a payment. Goods should not be sent to a struggling customer until the promised payment is received. Goods that are shipped merely in anticipation of a payment will not fall under the new value exception. Complete all paperwork associated with any transaction. Copies of invoices and bills of lading are necessary to prove the exact date that goods were shipped to customers. Additionally, the date that payments are received is also integral to asserting the subsequent new value defense so accounts receivable records must be complete and accurate. Therefore, employees should be instructed to complete all paperwork as each transaction is processed U.S.C. 547(c)(1) (2000 and Supp. 2005). 25 See Pine Top Ins. Co. v. Bank of Am. Nat l Trust & Sav. Ass n, 996 F.3d 321, 328 (7th Cir. 1992) (holding a delay of two or three weeks substantially contemporaneous). But see In re Arnett, 731 F.2d 358, 363 (6th Cir. 1984) (holding 33 day delay to be not substantially contemporaneous) U.S.C. 547(c)(4) (2000). 5 OCTOBER 2005 KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP

6 The Ordinary Course of Business Defense The ordinary course of business defense is the most common defense in a preference action. Congress has allowed creditors to assert this defense because it encourages creditors to continue dealing with failing companies. The primary purpose for this defense is to protect regular credit transactions that occur during the ordinary course of business between the debtor and the creditor. To assert this defense successfully, the creditor must prove each of the following elements: The transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and creditor; and (A) The transfer was made in the ordinary course of business between the debtor and creditor; or (B) The transfer was made in accordance with ordinary business terms. 27 To increase the likelihood that a court will find that payments made to the creditor were made in the ordinary course of business, a creditor should do the following: Ensure that all transactions and communications with the customer remain consistent with previous dealings. In order to assert the ordinary course of business defense against a customer who has filed for bankruptcy, the creditor must maintain its normal relationship with that customer. 28 If a creditor aggressively seeks payments from a struggling customer, the creditor is almost guaranteeing that a trustee or debtor in possession will avoid the preferential payments if the customer files for bankruptcy. Unless a creditor is able to secure payment for goods before shipment, it should not alter its debt collection methods with the customer. Creditors should make sure that every transaction with a struggling customer is in the ordinary course of business. Be conscious that any accelerating change in collection practices increases the risk of being liable on a preference claim. To assert the ordinary course of business defense successfully, a creditor should ensure that the timing of the customer s payments is consistent with the previous payment history. If a customer typically pays its debts forty days after it is invoiced for them, it is best if this practice continues. Do not allow abnormally late payments. Just like early payments, abnormally late payments will fall outside of the ordinary course of business between the parties. Any significant change in a payment pattern is sufficient to remove a transaction from the ordinary course of business exception. 29 While late payments may be ordinary between the parties, the payments must fall within the normal range of lateness. 30 Maintain the same form of payment. If a customer has a history of paying by check, a creditor should not request payment by wire transfer or through certified funds. Although these forms of payment are more dependable than a check, a new payment method will not be in the ordinary course of business between the parties. As a result, the creditor usually will be forced to return these payments to the debtor if the payments fall within the applicable preference period. Remain informed about the ordinary practice of debtors and creditors in their particular industry and region U.S.C. 547(c)(2) ( effective Oct. 17, 2005). The amendment allows creditors to prove only two of the three elements to successfully argue the defense. Previously, the creditor had to prove all three elements to succeed in arguing the ordinary course of business defense. 28 Although dealings should remain consistent, many circuits are finding that creditors without a history of dealing with the debtor are not per se ineligible for the ordinary course of business defense. Kleven v. Household Bank F.S.B., 334 F.3d 638, (7th Cir. 2003). For example, performance in accordance with the terms of the parties agreement can show transaction is within ordinary course of business. Id. 29 Concast Canada, Inc. v. Laclede Steel Co. (In re Laclede Steel Co.), 271 B.R. 127, 131 (B.A.P. 8th Cir. 2002). 30 Id. at 133 (finding that payments made 177 days beyond the ship date were not within the ordinary course of business of the parties when payments were usually made on average 52 days following ship date). 6 OCTOBER 2005 KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP

7 Most circuit courts agree that ordinary business terms are a broad range of terms that encompass the practices in which firms similar in some general way to the creditor engage in business and only dealings that are extraordinarily idiosyncratic should be deemed outside the ordinary business terms. 31 Creditors must maintain a general understanding of whether late payments of invoices are commonly accepted, and of what is considered to be a late payment in the industry. The ordinary course of business defense appears attractive to creditors who believe they have done nothing wrong with respect to a bankrupt debtor. This defense can be a strong negotiating tool, but it typically requires a costly trial to resolve. Ordinary course of business defenses frequently provide the creditor and the debtor with good reasons to settle. CONCLUSION AS TO PREFERENCE DEFENSES In evaluating a preference claim, creditors should determine how valuable it is to retain the debtor s entire payment. Although a creditor might be able to retain the preferential payment by prevailing at trial, the creditor should estimate the cost and risk of litigation and consider settling for a portion of the payment. Most preference actions are resolved without a trial, and a settlement is often best for both the debtor and the creditor. To the extent the estate recovers a transfer as a preference either through litigation or settlement, the creditor returning such transfer has an allowed claim of the same status as a claim existing at the date of the filing of the petition, if the claim is not otherwise disallowed. 11 U.S.C. 502(h) (2000). Therefore, the creditor should file a proof of claim for the amount returned to the estate. TIPS FOR RECLAMATION DEMANDS Reclamation is the right of a seller to repossess goods delivered to an insolvent or bankrupt buyer. This reclamation right allows a creditor to repossess some of the goods it sold to a debtor for which it has not been paid instead of relying solely on a proof of claim for an unsecured claim to recover a small portion of its loss. The Bankruptcy Code allows for a right of reclamation that expressly defeats the rights and powers of the trustee under 544(a), 545, 547, and 549. In addition to providing step-by-step instructions for drafting demands for reclamation, this Alert highlights recent changes made to the Bankruptcy Code pursuant to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 that are effective October 17, As amended, 546(c) states: (1) Except as provided in subsection (d) of this section and in section 507(c), and subject to the prior rights of a holder of a security interest in such goods or the proceeds thereof, the rights and powers of a the trustee under sections 544(a), 545, 547, and 549 of this title are subject to any statutory or common-law the 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, within 45 days before the date of the commencement of a case under this title, but (1) such seller may not reclaim any such goods unless such seller demands in writing reclamation of such goods (A) before 10 not later than 45 days after the date of receipt of such goods by the debtor; or (B) not later than 20 days after the date of commencement of the case, if such 10-day the 45-day period expires after the commencement of the case., before 20 days after receipt of such goods by the debtor; and (2) If a seller of goods fails to provide notice in the manner described in paragraph 1, the seller may still assert the rights contained in section 503(b)(9). 31 Ganis Credit Corp. v. Anderson (In re Jan Weilert RV, Inc.), 315 F.3d 1192, 1197 (9th Cir. 2003); In re Gulf City Foods, Inc., 296 F.3d 363, 369; Lawson v. Ford Motor Co. (In re Roblin Indus., Inc.), 78 F.3d 30, 42 (2d Cir. 1996); Luper v. Columbia Gas of Ohio, Inc. (In re Carled), 91 F.3d 811, 818 (6th Cir. 1996); Fiber-Lite Corp. v. Molded Acoustical Prods., Inc. (In re Molded Acoustical Prods., Inc.), 18 F.3d 217, (3d Cir. 1994); Advo-System, Inc. v. Maxway Corp., 37 F.3d 1044, 1050 (4th Cir. 1994); Jones v. United Sav. and Loan Ass n (In re U.S.A. Inns of Eureka Springs, Inc.), 9 F.3d 680, 685 (8th Cir. 1993); In re Tolena Pizza Prods. Corp., 3 F.3d 1029, 1031 (7th Cir. 1993). 7 OCTOBER 2005 KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP

8 (2) 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 seller priority as a claim of a kind specified in section 503(b) of this title; or (B) secures such claim by a lien. (Amendments redlined.) 32 In plainer terms, the statute requires four conditions to be met in order for a seller to assert a right of reclamation successfully and repossess its goods: the seller sold the goods on credit to the debtor in the ordinary course of business of both the seller and the debtor; the debtor received the goods within forty-five days of filing its bankruptcy petition; the debtor was insolvent at the time of receipt; and the seller made a written demand for the return of the goods (a) within forty-five days after the goods were delivered to the debtor or (b) within twenty days after the commencement of the case, if the forty-five day period would otherwise close after the debtor files its petition. 33 The bankruptcy courts have also construed 546(c) of the Bankruptcy Code to include two additional elements: the debtor possessed the goods at the time of the reclamation demand; and the goods must be identifiable at the time of the demand. The reclaiming seller must establish each condition or element by a preponderance of the evidence. In order to meet this burden, it is imperative that the seller keep thorough and accurate records, and to the maximum extent possible, obtain similar accounting or confirmations of receipt of identifiable goods from buyers on the brink of insolvency. 34 THE SIX ELEMENTS OF 546(c)(1) Credit Sale in the Ordinary Course of Business The first element requires that the sale of goods in question be made in the ordinary course of the seller s business. The evidence necessary to meet this element is similar to that required in asserting the 547(c) ordinary course of business defense in a preference action. As outlined in Section I, the seller should have a recorded history of past transactions between the parties to show that the sale in question followed the pattern of its ordinary course of business. Debtor Received Goods within 45 Days of Bankruptcy Petition The second element requires the seller to show that the goods were received by the buyer within fortyfive days before the date of the commencement of the buyer s bankruptcy case. Accurate shipping records should give the seller a time frame within which the debtor likely received the goods. However, a request for acknowledgement of receipt from its buyers would provide the seller with more definite proof that the debtor received the goods within forty-five days before the filing of the buyer s bankruptcy case. 35 An Insolvent Buyer at the Time the Goods are Received The third element requires the seller to prove that the debtor/buyer was insolvent at the time of its receipt of the goods. The seller must present evidence of the buyer s insolvency at the time of receipt because courts will not apply the presumption of insolvency used for preference purposes under 547(f) U.S.C. 546(c) (2005) (effective Oct. 17, 2005). The prior version of 546(c) required the seller to make its written demand within ten days after receipt of the goods by the debtor. The right to reclamation under prior 546(c) had to arise out of a non-bankruptcy common law or statutory right, typically the state law version of Uniform Commercial Code ( UCC ) section 2-702(2). In addition to these changes, the most recent version of 546(c) removes the bankruptcy court s discretion to grant the seller an administrative priority claim or a lien rather than repossession of the goods. 33 See In re Georgetown Steel Co., 318 B.R. 336, 339 (Bankr. D.S.C. 2004). 34 For example, the court in In re Georgetown Steel Co. stated that no presumption that the Debtor is in possession of the goods in question on the date of the reclamation demand arises from proof that the goods were delivered to the debtor. Id. at To determine the date of receipt by the debtor for purposes of 546(c), courts generally rely on the definition of the word receipt set forth in section of the UCC. Section of the UCC defines receipt of goods as taking physical control of them. See 5 Collier on Bankruptcy (Lawrence P. King et al. eds., 15th ed. rev. 2005). 36 In re Victory Mkts., 212 B.R. 738, 741 (Bankr. N.D.N.Y. 1997); In re Morken, 182 B.R. 1007, 1021 (Bankr. D. Minn. 1995). 8 OCTOBER 2005 KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP

9 Insolvent is defined in the Bankruptcy Code as a financial condition such that the sum of such entity s debts is greater than all of such entity s property, at a fair valuation. 37 It would benefit the seller to send out regular requests for certification or evidence of solvency to troubled buyers receiving goods on credit. A buyer s inability or unwillingness to provide the certification may be some evidence of insolvency, and at the least will alert the seller to the possibility of such financial condition. In any event, the seller should create a paper trail of regularly monitored information relating to the buyer s solvency. A Timely Written Demand for Reclamation The fourth element, a timely written demand for reclamation, is perhaps the only element over which the diligent seller can exercise complete control. Section 546(c) requires that the written demand, or reclamation letter, be made within one of the following two time frames. First, a demand may be made within forty-five days of the debtor s receipt of the goods. This time frame would apply where the seller becomes aware of the buyer s insolvency, but the buyer has not yet filed its petition for bankruptcy. 38 However, sellers may be unaware, or at least uncertain, of a buyer s insolvency until its bankruptcy petition is filed. To accommodate this reality, 546(c)(1)(B) extends the demand period for twenty calendar days after the date of commencement of the bankruptcy case if the expiration of the original forty-five day period would otherwise occur after the debtor files for bankruptcy. Regardless of how the seller learns of the debtor s insolvency, the first step is to determine if any shipments were made to the debtor within the previous forty-five days. If so, a reclamation demand letter referring to these shipments should be sent immediately. This ensures that a timely demand is made within forty-five days of the debtor s receipt of the goods (if prior to the bankruptcy filing), or within the twenty days after the bankruptcy petition is filed. Even if it is later determined that the seller does not have a valid reclamation right (because of a prior secured interest in the goods, perhaps), timeliness is essential, and there is no penalty for merely sending the letter. Proof that such a letter was sent will be required by the court at some point. It would behoove the seller to send the demand letter by certified mail or fax the letter and keep the fax confirmation sheet. Some courts require the seller to pursue its claim further by filing a motion or adversary proceeding. 39 The Debtor Possesses the Goods when the Reclamation Letter is Received The fifth element, proof that the goods were in the possession of the debtor at the time of receiving the reclamation demand, is not specifically provided for in 546(c). Bankruptcy courts find this implicit element in case law under the Uniform Commercial Code (UCC), which routinely held that a seller could only reclaim goods in the buyer s possession. 40 Because Congress designed 546(c) of the Bankruptcy Code to recognize a seller s state law UCC section reclamation right in the bankruptcy context, 41 the possession element has been transferred into bankruptcy law by the courts. The seller can meet its burden of proof on this element by demanding that the debtor (i) take an inventory of the goods identified in the reclamation letter as soon as the letter is received and (ii) supply the results to the seller. If practical, the seller should follow up with an immediate visit to the debtor s premises to verify the accuracy of the inventory. These steps should generate the evidence necessary for the seller to assert its reclamation right. Ideally, the seller will have accurate records on hand sufficient to meet each element of its reclamation claim. Such records provide the seller with leverage for a consensual agreement with the debtor or trustee to return the goods, or at least provide an administrative expense priority in bankruptcy, thereby avoiding the litigation expense of an adversary proceeding. Identification of Goods The sixth element is that the goods must be identifiable. Although neither UCC section nor 546(c) of the Bankruptcy Code require the U.S.C. 101(32) (2000 and Supp. 2005). 38 Of course, for 546(c) to apply, the buyer must eventually file a petition for bankruptcy within the forty-five days after receiving the goods. 39 McLouth Steel Prods. Corp. v. Quaker Chem. Co. (In re McLouth Prods. Corp.), 213 B.R. 978, 987 (Bankr. E.D. Mich. 1997). 40 In re Adventist Living Ctrs., 52 F.3d 159, 163 (7th Cir. 1995). 41 In re Pester Refining Co., 964 F.2d 842, 845 (8th Cir. 1992). 9 OCTOBER 2005 KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP

10 seller s demand letters to provide all the information needed to determine the identity of the reclamation goods, a seller should provide as much information as is available. Identification is not the sole responsibility of the seller. 42 The Debtor must take the information in the demand letter and the information in its possession to determine what goods are identifiable. Only identifiable goods are subjects of reclamation claims. THE ALTERNATIVE REMEDY OF 546(c)(2) The seller cannot repossess its goods if these six elements are not proven by a preponderance of the evidence. However, if the reclamation letter is the only deficiency in the seller s claim, it may still receive the value of any goods delivered to the debtor within the twenty days before bankruptcy. Section 546(c)(2) allows the seller who fails to provide notice in the manner described in paragraph (1) [to] assert the rights contained in section 503(b)(9). 43 Section 503 governs various types of administrative expenses, which are given a priority over almost all other unsecured claims against the bankruptcy estate. 44 Administrative expenses include the value of any goods received by the debtor within 20 days before the date of the commencement of a case in which the goods have been sold to the debtor in the ordinary course of the debtor s business. 45 Two concerns must be addressed by the seller if it wishes to receive an administrative expense for the value of its delivered goods. First, it must be shown (presumably by the seller) that the goods were sold to the debtor in the ordinary course of the debtor s business. 46 Because 503(b)(9) is an addition to the Bankruptcy Code, it is unclear whether this new language will be given its plain meaning, or whether it will be interpreted to mean debtor s and seller s business. In other words, if there is no prior business history between the debtor and seller other than the transaction in question, can the seller assert a 503(b)(9) claim solely by showing that the debtor acquired goods from other sellers in a similar manner? If the 503(b)(9) administrative expense claim is intended to be a secondary remedy for sellers unable to meet the stringent elements of 546(c)(1), courts should not raise the seller s evidentiary burden by diverging from the plain statutory language. Second, it is important to note the narrower time frame of 503(b)(9). The debtor must receive the goods within the twenty days before the bankruptcy filing, as opposed to 546(c)(1) s broader forty-five day period. The time gap underscores the importance of the written demand for reclamation: if the debtor/buyer files for bankruptcy between twentyone and forty-five days after receiving the goods and the seller fails to make a timely written demand, neither an administrative expense claim nor a right of reclamation are available. The seller is left with the same pro rata, cents-on-the-dollar claim as other unsecured creditors. RECLAMATION LETTER GUIDELINES While 546(c)(1) speaks only to the timing of the written demand for reclamation, the contents of such a letter are equally important. A well-drafted letter will not only notify the debtor of the seller s asserted right of reclamation, but will also help preserve that right to the fullest extent possible in the bankruptcy court. Generally, the letter should conform to the following guidelines: The letter should be addressed to the attention of a specific person, preferably an officer, at the debtor s corporate headquarters. The seller should also send a copy to a specific person at the address to which the goods were shipped, and should copy the debtor s bankruptcy counsel, if known. The letter should identify the seller s company and all names under which the seller sold goods to the debtor. The letter should specifically state that the seller is asserting its right of reclamation under 546(c) of the Bankruptcy Code. The letter should fully describe the shipped goods. This includes the date on which the goods were shipped and received, the nature or identity of the goods, and the location to which 42 Scotts Co. v. Hechinger Co. (In re Hechinger Investment Co. of Delaware, Inc.), 274 B.R. 402 (Bankr. D. Del. 2001) U.S.C. 546(c)(2) (effective Oct. 17, 2005) U.S.C. 507(a)(2) (effective Oct. 17, 2005). Secured claims and unsecured claims for domestic support obligations will be paid prior to 503(b) administrative expenses. 11 U.S.C. 507(a)(1) (effective Oct. 17, 2005) U.S.C. 503(b)(9) (effective Oct. 17, 2005). 45 Id. 10 OCTOBER 2005 KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP

11 the goods were shipped. Copies of invoices or other documentation should be attached. The description should be as complete as possible. The letter should include the following requests: that the debtor account for the goods and take an inventory of what goods are on hand at the time the demand is received; that the debtor send the seller the results of the inventory; that the debtor segregate the goods identified in the letter; and that the debtor refrain from selling or otherwise disposing of the reclaimed goods. A letter that conforms to these guidelines will help to prove the seller s asserted right of reclamation, especially if the debtor fully complies with the letter s requests. This notice to the debtor, while necessary, is not always sufficient to protect the seller s rights. Therefore, it is also good practice to request permission from the debtor to visit its premises and ensure that the identified goods are present and segregated. and assure through its conduct, that it is engaging in these activities and issuing its demand letter solely as permitted by, and pursuant to, its reclamation rights under 546(c) of the Bankruptcy Code and for no other purpose. CONCLUSION AS TO RECLAMATION RIGHTS Dealing with an insolvent buyer is never ideal. Even a seller who can prove each of the 546(c) elements of reclamation may not receive a full recovery if, for example, the buyer has resold the goods or if there is a lender with a blanket lien on the goods. However, the vigilant seller who acts quickly and aggressively to protect its rights, and who keeps current and accurate records, has the best chance of improving its position in bankruptcy through the statutory right of reclamation. David A. Murdoch dmurdoch@klng.com Jamie Bishop jbishop@klng.com In order to avoid a claim by the debtor that the seller is violating the automatic stay and should be held in contempt of court, the seller should state in the letter, 11 OCTOBER 2005 KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP

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