Consider the plight of a manufacturer of women’s blouses who sells her finished product to every major department store and specialty store chain in the country. One of her highest volume customers is a 150 store chain of up-scale boutiques located in the metropolitan areas of the largest cities in the United States. Let’s call the manufacturer “Better Blouses, Inc.” and the boutique chain, “Le Boutique” (both names are fictitious and any resemblance to actual business names is purely coincidental). Better Blouses’ New York salesman has taken orders from Le Boutique for the Spring line at his New York Showroom; $3,000 per store. A nice order totaling $450,000!

When Better Blouses received the order confirmation, the company’s credit manager advised her factor, who gave a tentative approval of the credit. Piece goods and trim were ordered, the goods were put into work and the complete order was ready to be shipped when the factor called and advised that the credit approval had been withdrawn.

Panic set in.

The credit manager called the chief financial officer of Le Boutique and was given assurances that everything was fine; there was a temporary cash flow problem and the factors were giving Le Boutique a rough time. “Don’t worry. Ship the goods and you’ll be paid. In fact we will pay in 30 days even though your terms are net 60.” The credit manager then phoned the New York salesman and was told by him, “They’re as good as gold. Everyone’s shipping! Your factor has a new man on the credit desk and is being over cautious.” The credit manager presented the situation to Better Blouses’ CEO who decided to ship the orders without factor approval. (Sound familiar?)

Two days after the goods were shipped to the Le Boutique distribution center, the headlines in Women’s Wear Dailywere “Le Boutique Files Chapter 11.” The goods were received by La Boutique’s distribution center the day before the bankruptcy was filed. Here are some of the options Better Blouses should consider:

Reclamation

The reclamation provision of the Bankruptcy Code is found in Section 546(c). It traces its origins to the common law under which an unpaid seller of goods who was defrauded into extending unsecured credit to a buyer had the right to rescind the sale and recover the goods. This common law right was eventually codified in Uniform Commercial Code Section 2702. The Bankruptcy Code adopted Section 2702, but only in part. The Bankruptcy Reform Act of 1994 extended the 10-day reclamation period found in the Uniform Commercial Code to 20 days and the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BACPA”) further extended the reclamation period to 45 days.

However, the Bankruptcy Code provides that the avoiding powers given to the bankruptcy trustee are only subject to the reclamation rights of a seller who sold goods to the debtor in the ordinary course of business while the debtor was insolvent.

Thus, even though the seller’s reclamation rights may find their underpinnings in the common law and in the UCC, there are strict limitations on the seller’s reclamation rights under the Bankruptcy Code. One must consider the following restrictions imposed by Bankruptcy law:

  • The first restriction requires that the sale of goods must have been in the ordinary course of the seller’s business. Thus, a bulk sale, will, in most instances, not be in the seller’s ordinary course of business and not come under the purview of the Bankruptcy Code reclamation provisions.
  • The second limitation is that a seller cannot reclaim goods unless the reclamation is demanded in writing within 45 days after the debtor received the goods or, not later than 20 days after the date of the commencement of the case if the 45 day period expires after the commencement of the case. There is a significant difference in this provision when compared to UCC § 2702. Under the UCC, the seller can be relieved from making the demand in writing if the buyer made a written misrepresentation as to the buyer’s solvency within three months preceding the delivery of the goods.
  • The third limitation is that the right to reclaim goods is limited to the merchandise remaining in the debtor’s possession at the time that the seller’ demand for reclamation is received. A reclamation claim cannot be exercised with respect to goods already sold by the debtor.
  • There may be a fourth limitation with regard to applicable state law. An unpaid seller’s reclamation rights are subject to the rights of buyers in the ordinary course of business and good faith purchases under whatever state law may apply. (This was the issue in a Ninth Circuit case decided in 1984, In Re Coast Trading Co., 744 F2d 686.)

The Bankruptcy Code allows the bankruptcy judge to select one of three treatments to be given to a seller’s reclamation rights if a proper written demand is made within the 45 day period: (1) the Court may grant the seller’s request for possession of the goods, (2) the Court may also deny reclamation and grant the seller’s claim as an administrative expense priority, or (3) the Court may grant the reclaiming seller a lien on the goods sought to be reclaimed or on some other property of the estate, thus converting the unsecured reclaiming seller to a secured creditor.

Reclamation, although appearing rather simple at first glance, is a remedy that requires reference to the expanding body of case law that has interpreted Bankruptcy Code Section 546(c). The over-used term “a trap for the unwary” is exemplified by the reclamation issues that can arise in a Chapter 11 reorganization case.

Since Better Blouses shipped the goods in question within the last 2 days and the presumption of Le Boutique’s insolvency exists due to the bankruptcy filing, a reclamation demand letter would appear to be an appropriate course of action.

A Priority Claim

BACPA added as Section 503 (b) (9) a new provision for unsecured creditors which provides that after notice and a hearing, there shall be allowed as an administrative expense the value of any goods received by the debtor within 20 days before the date of commencement of the case in which the goods have been sold to the debtor in the ordinary course of the debtor’s business. That means that a qualifying creditor should get paid before general unsecured creditors as a priority expense.

Different bankruptcy courts have established different procedures to assert such a priority claim. Some courts have required a formal motion to be filed while others require only a demand letter. Still others require the filing of a proof of claim with a request for a hearing. Procedures for asserting these claims are generally established early in the case.

Request for Notice

A great deal of court activity takes place in the early stages of a Chapter 11 case: financing motions, motions for authority to pay employee wages, honor gift certificates, pay critical vendors and to retain professionals – to name a few activities which might affect the outcome of the case. Although Better Blouses may be one of the twenty largest creditors who are ordinarily included on the list to receive notice of all court filings, the company should consider filing a “Request for Notice,” which should be served on all of the individuals and entities shown on the master mailing list that the debtor has filed with the court.

After a request for notice is filed and served Better Blouses should receive copies of everything that is filed with the Bankruptcy Court in the Le Boutique case.

Proof of Claim

Better Blouses should also consider filing a proof of claim as soon as possible. Even though a reclamation demand has been made, a separate reclamation proof of claim should be prepared and filed with the clerk of the Bankruptcy Court. If money is owed to Better Blouses because of prior unpaid shipments that were not shipped with factor approval, a separate proof of claim should also be filed. Although most factors will be diligent in filing proofs of claim on their own behalf it wouldn’t hurt to gently remind the factor to file a proof of claim to include whatever money is owed to Better Blouses by the debtor.

The Creditors’ Committee

Better Blouses should consider serving on the Unsecured Creditors’ Committee, if it is eligible to do so.

Le Boutique is required to file with the court a list of its twenty largest unsecured creditors. From that list a committee of five to seven creditors will be appointed by the United States Trustee serving the court where the bankruptcy is pending. Creditors who are on the “Top 20″ list are invited to complete a very simple questionnaire if they want to serve on the Committee whose official name is the “Committee of Creditors Holding Unsecured Claims.”

Service on the “Committee” can be an enlightening experience. The Committee may consult with the debtor concerning the administration of the case to investigate the acts, conduct, assets, liabilities and financial condition of the debtor; the operation of the debtor’s business; the desirability of the continuance of such business; and any other matter relevant to the case or to the formulation of a plan of reorganization. The Committee may participate in the formulation of a plan of reorganization, advise those represented by the Committee of the Committee’s determinations as to any plan that is formulated, and collect and file with the court acceptances or rejections of the plan. The Committee can also request the appointment of an examiner or a trustee to take over the operation of the debtor’s business.

The Bankruptcy Code, in Section 1103 gives the Committee very broad powers to perform “such other services as are in the interest of those represented.”

The Committee can retain the services of attorneys, accountants and other professionals at the expense of the bankruptcy estate. Although Committee members are not paid for their services, they can be reimbursed for reasonable and necessary expenses incurred in carrying out their duties. These usually include transportation, meals and lodging expenses.

Preferences and Fraudulent Transfers

In proceedings under Chapter 11, as well as all other chapters, the debtor, through its financial advisors may conduct an analysis of preferences and fraudulent transfers that may be recovered to increase the debtor’s estate. These activities require not only a thorough comprehension of the debtor’s bookkeeping systems and methods, but an in depth knowledge of applicable bankruptcy law. The debtor’s bankruptcy professionals will be called upon to analyze insider preferences, non insider preferences and fraudulent transfers. Insider preferences are those which occur within the one year period prior to the filing of bankruptcy to those individuals and entities designated as “insiders” under section 101(31) of the Bankruptcy Code. Non insider preferences are those which occur within the ninety days preceding the filing of the bankruptcy. Fraudulent transfers under Section 548 of the Bankruptcy Code are those which occur within the year preceding the filing of the bankruptcy. However, under state law, the Uniform Fraudulent Transfer Act (Civil Code Sections 3439, et seq.) the bankruptcy trustee, or the debtor in possession, can recover fraudulent transfers that were made within four years, and in some cases up to seven (7) years prior to the time the bankruptcy petition is filed.

If Better Blouses received payment from the debtor on non-factored invoices within the 90 days preceding the commencement of Le Boutique’s bankruptcy case, and such payment was for past due amounts, a claim against Better Blouses to recover the preferential amount may available to the debtor. Better Blouses financial personnel should start gathering documentation to support one or more of the several defenses to preference actions.

A fraudulent transfer claim against Better Blouses, although highly unlikely, might also be brought under the appropriate circumstances. Consider a situation involving the sale of goods for $100 per garment and the buyer runs into financial difficulty. He asks the seller to take back the goods for full credit. The seller refuses to do so but will take them back for a credit of 30 cents on the dollar. The buyer agrees, returns the goods, gets the credit and files bankruptcy. The debtor or a trustee then sues the seller on a fraudulent transfer theory claiming that the buyer received less than fair equivalent value on the return and demand the payment of the other 70 cents on the dollar. Yes, that could really happen!

Trademark Protection

If Better Blouses sold Le Boutique pursuant to a distribution or license agreement that provided certain protections for Better Blouses’ trademarks, consideration should be given to the debtors’ intentions regarding the liquidation of its inventory to raise money for operations.

Frequently several poor performing stores in a retail chain are closed by turning them over to a liquidator. There are so many variances in what liquidators can do that they cannot be thoroughly discussed in this article; however, if Better Blouses has trademarked goods in the stores and the trademarks are carefully policed, consideration should be given to initiating appropriate actions in the bankruptcy court to prevent diminution of the value of the marks.

Disclosure Statement and Plan of Reorganization

At some point in the Chapter 11 case, Le Boutique may prepare and file a Plan of Reorganization. However, if the plan provides for anything other than full payment to all creditors, a Disclosure Statement must be prepared and court approval of its provisions must be obtained before consents to the Plan can be solicited. The Disclosure Statement must contain sufficient informant to enable a creditor to determine whether or not to vote in favor of the Plan.

Better Blouses should await the receipt of the Disclosure Statement, read it carefully and then decide whether to vote in favor of or against the plan.