Court Opinion

ID: 9521065
Source: CourtListenerOpinion
Date Created: 2023-08-07 01:56:18.431057+00
Date Added: 2024-06-11T12:47:35.698885
License: Public Domain

LATTA, Bankruptcy Judge,
dissenting.
I agree with my colleagues that, as an initial matter, the Appellants’ rights can be no greater in bankruptcy than they would have been outside of bankruptcy. I further agree that, pursuant to the Post-Petition Financing Order, the claims of the Appellants were subordinated to the liens of the DIP Lender and that the value of the Appellants’ claims cannot exceed the value of those claims outside of bankruptcy. Because I believe that the reclamation claims were not extinguished by the Post-Petition Financing Order, and thus that the bankruptcy court erred in failing to assign them administrative expense or junior lien status as of the date of demand, and further, because I believe that the bankruptcy court erred in failing to require that the Debtor seek its requested relief by way of adversary proceeding, I respectfully dissent, and would remand this case to the bankruptcy court for further proceedings.
It is apparently undisputed that as of the date of the filing of the bankruptcy petition, the Debtor was indebted to the Prepetition Lenders in the maximum amount of $115 million and that the indebtedness was secured by inventory with a value of $245 million. The claims of the Prepetition Lenders were over-secured in the amount of $130 million. The Appellants made timely reclamation demands at or near the date of the filing of the petition. Pursuant to the claims liquidation process provided for in the Reclamation Procedures Order, reclamation claims in the approximate amount of $2.9 million were validated by the Debtor as supported by goods that were (i) in the possession of the Debtor, (ii) specifically identifiable, and (iii) unconverted as to form, in each case as of the date on which the reclamation demand was received by the Debtors.
Pursuant to the PosL-Petition Financing Order, the Prepetition Lenders were paid in full, and the DIP Lender was granted superpriority status pursuant to § 364(c) of the Bankruptcy Code and a floating lien upon all inventory and proceeds with priority over all administrative expense claims including reclamation claims.
Some two years later, at the hearing on the Debtor’s Reclamation Motion, the Debtor offered proof that following validation of the Appellants’ claims, all goods subject to those claims had been consumed in the manufacturing process, the final products sold, and the proceeds paid to the DIP Lender. The Appellants argued that the Prepetition Lender was over-secured *293at the time their demands were made, but were unable to offer proof as to the status of the security interests held by the DIP Lender. Rather, the Appellants argued that the Debtor should have filed an adversary complaint to determine the extent, validity and priority of their claims, which would have given them the opportunity to gather evidence about the liens through discovery. The bankruptcy court overruled the Appellants’ objections and granted the Debtor’s motion. The court held that reclaiming sellers have no greater rights in bankruptcy than they hold under state law, and that under applicable state law, a seller’s rights are exclusively limited to recovery of goods sold. Inasmuch as the goods subject to the Appellants’ reclamation demands were consumed by the debtor in possession in the manufacturing process, they were no longer available for recovery, and the sellers’ rights were extinguished. Thus, as the sellers had no rights under state law, they had no right to a priority claim under bankruptcy law.
The bankruptcy court failed to recognize that, even under state law, reclamation claims can extend to identifiable proceeds of reclaimed goods sold to satisfy a prior security interest. Further, the court failed to recognize that the Bankruptcy Code specifically provides a substitutionary remedy for reclaiming sellers whose goods are to be consumed in the administration of a bankruptcy estate. Upon a showing of the validity of the reclaiming sellers’ claims, the bankruptcy court should have granted the reclaiming sellers an administrative claim or lien junior to the DIP Facility, while leaving the determination of the value of the claims to a later, meaningful time.
A.
At the time of their reclamation demands, the Appellants had claims under Uniform Commercial Code § 2-702 that were supported by existing and identifiable goods in the possession of the Debtor. At the time of demand, there was more than adequate inventory to pay the Pre-petition Lender’s claim without resort to the goods subject to the reclamation demands. As such, unless the prior secured claims automatically extinguished the reclaiming sellers’ claims, proceeds from the sale of the Debtor’s inventory could have satisfied both the Prepetition Lender’s claim and the Appellants’ claims. See United States v. Westside Bank, 732 F.2d 1258, 1265 (5th Cir.1984) (Foreclosure by a secured creditor does not cut off the rights of a reclaiming seller to identifiable proceeds not needed to satisfy prior liens.).
Under the Uniform Commercial Code, the rights of a reclaiming seller are not extinguished by, but are inferior to those of a secured creditor and superior to those of the buyer’s general unsecured creditors. See Pester Refining Co. v. Ethyl Corp. (In re Pester Refining Co.), 964 F.2d 842, 845-46 (8th Cir.1992). Outside of bankruptcy, in the event of liquidation, good faith would require the secured creditor to liquidate its collateral in such a way as not unnecessarily impair the rights of junior lien holders or reclaiming sellers. Toshiba America, Inc. v. Video King of Illinois, Inc. (In re Video King of Illinois, Inc.), 100 B.R. 1008, 1014 (Bankr.N.D.Ill.1989). In that event, if the secured creditor were over-secured, junior lien holders and reclaiming sellers could expect to be paid from the proceeds of goods subject to their interests ahead of unsecured creditors. Westside Bank, 732 F.2d at 1265; In re Victory Markets, Inc., 212 B.R. 738, 743 (Bankr.N.D.N.Y.1997); American Saw & Mfg. Co. v. Bosler Supply Group (In re Bosler Supply Group), 74 B.R. 250, 253 (N.D.Ill.1987). See also 4 White and Summers, Uniform Commercial Code § 32-10, n. 29 (West 5th ed.2002).
*294Similarly, in the bankruptcy context, Bankruptcy Code section 546(c) makes a trustee’s or debtor in possession’s rights subordinate to those of a reclaiming seller. That section specifically empowers a bankruptcy court to permit a debtor in possession to consume goods subject to a reclamation demand in its ongoing business, provided that the rights of the reclaiming seller are protected. In exchange for the debtor in possession’s use of goods subject to reclamation, reclaiming sellers are granted administrative expense or junior lien priority. Section 546(c)’s grant of priority is a substitutionary remedy. It substitutes a priority claim for the reclaiming seller’s interest in the goods sold, and thus permits a debtor in possession to continue in business without having to return goods subject to reclamation. This remedy is not available in addition to reclamation rights, but in lieu of turning over the property. In effect, the Bankruptcy Code treats the valid right of reclamation as a perfected security interest or lien. See 11 U.S.C. § 101(37); see also Westside Bank, 732 F.2d at 1265.
Pursuant to section 546(c)(2), once the Appellants established the validity of their reclamation claims' — that is that the claims were supported by goods that were in the possession of the Debtors, specifically identifiable, and uncontroverted as to form, as of the date on which the reclamation demand was received by the Debtors — them right to protection in the event that the debtor in possession sought to use the goods was established. Because the reclamation claims were specifically subordinated to the DIP Lender by the Post-Petition Financing Order, the value of those claims remained in question. Pursuant to section 546(c)(2), they should have been treated as junior liens, subordinate to the lien of the DIP Lender. The value of those liens then would have been determined at an appropriate time, such as in connection with the confirmation of a plan, or a sale of assets outside of the ordinary course of business.
The rights of reclaiming sellers are fixed as of the demand for reclamation. In re Victory Markets, Inc., 212 B.R. at 744. Satisfaction of a secured creditor’s under-secured claim may reduce the value of any recovery pursuant to those rights, even to zero, but cannot extinguish those rights. Id. at 743 (“If the secured creditor’s rights are superior to the seller’s, the seller is left with a nonpriority unsecured claim as to the value of goods subject to the superior secured creditor’s claim, and a right of reclamation as to the goods or value which are in excess of the creditor’s claim.”). See also Matter of Reliable Drug Stores, Inc., 70 F.3d 948, 950 (7th Cir.1995) (“How much a particular reclamation claim is worth, once § 546(c)(2)(A) transmutes it into an administrative claim, is a question distinct from the ‘validity’ of the reclamation claim.”). In this case, however, it appears that the claims of the Prepetition Lenders were over-secured, and that the claims of the DIP Lender were also, at least initially, over-secured. The Appellants were not permitted to determine whether the claims of the DIP Lender were over-secured at the time of the hearing on the Reclamation Motion, and it appears that time might have been an artificial one for determining the value of the reclamation claims in any event. The claims should have been evaluated in connection with some proposed disposition of the inventory, such as a plan or sale.
Once the validity of the reclaiming sellers’ claims had been established, the bankruptcy court erred in failing to provide the reclaiming sellers a remedy in exchange for the use of their goods. In this case, in which the Posh-Petition Financing Order provided for the subordination of reclamation claims, the most appropriate substitu-*295tionary remedy would appear to have been the securing of the claims by a junior lien. In that event, if at some later time it appeared that the assets securing the DIP Facility were inadequate, then the value of the Appellants’ liens might have been reduced or even eliminated. The value of a reclaiming seller’s claim need not be fixed as of the granting of the substitutionary remedy, but clearly the priority of these claims over general unsecured claims (and over a debtor in possession as hypothetical lien creditor) is to be established pursuant to section 546(c) before a debtor in possession is permitted to use goods subject to reclamation.
B.
Both Yenkin-Majestic Paint Corporation and Mississippi Lime Company urged the bankruptcy court that the Debtors’ motion presented questions as to the extent, validity and priority of liens and sought declaratory relief, and thus should be treated as an adversary proceeding, which would have provided them an opportunity for discovery. This issue was properly preserved for appeal. Despite Debtor’s arguments to the contrary, the Debtor’s motion clearly sought the determination of the extent, validity and priority of the Appellants’ claims and sought a declaration that those claims were generally unsecured. As such, the relief sought should have been brought by adversary complaint. See Fed. R. Bankr.P. 7001. The bankruptcy court erred in making determinations about the value of the Appellants’ liens outside of an adversary process.
CONCLUSION
The bankruptcy court erred in permitting the Debtor to consume goods subject to the reclamation claims of the Appellants without first protecting those rights by granting the Appellants a lien pursuant to section 546(c)(2). The court further erred in determining the value of the Appellants’ claims in connection with the Debtor’s motion rather than pursuant to adversary proceeding. Accordingly, I would reverse the decision of the bankruptcy court and remand this case for further proceedings consistent with this opinion.