The Bottom Line

Amidst a surge in retail bankruptcies, two recent decisions construing section 503(b)(9) of the Bankruptcy Code directly limit suppliers’ ability to seek administrative claims for goods shipped to a debtor in the period immediately prior to the bankruptcy filing. The decisions – one by the Third Circuit and the other by a Delaware bankruptcy court – focus on the meaning of “received” in section 503(b)(9) and hold that priority treatment requires “physical possession” by a debtor within 20 days of a bankruptcy filing. These decisions are important because vendors use a variety of means to transport goods for the benefit of merchants. As such, this narrow interpretation of “received” has broad implications for suppliers who utilize a global supply chain to manufacture, produce, and ship goods or who provide a retailer with, for example, direct-to-consumer shipping options. As the two cases show, one delivery method benefits the supplier while the other was a total shutout for the vendor.

What Happened

In re World Imports, Ltd. et al, Case No. 16-1357 (3d Cir. July 10, 2017)

World Imports involved two Chinese companies – Haining Wansheng Sofa Company and Fujian Zhangzhou Foreign Trade Company (the “Chinese Suppliers”) – who supplied furniture and similar goods to the debtor, World Imports. The goods at issue were shipped via common carrier to the United States “free on board” (FOB) at the port of origin in China, meaning that once the goods were delivered to the common carrier, the risk of loss or damage passed to World Imports. At the time World Imports filed for chapter 11 protection, the Chinese Suppliers’ goods had been delivered to the common carrier more than 20 days prior to the bankruptcy filing, but were physically received by World Imports within 20 days of the bankruptcy filing.

The dispute in World Imports arose after the Chinese Suppliers filed motions for the payment of administrative expense claims under section 503(b)(9) for the value of the goods received by World Imports. World Imports argued in response that the administrative expense motions should be denied because the goods should be deemed received by the debtor when they were received FOB by the common carrier outside the 20-day lookback period in section 503(b)(9).

The bankruptcy court sustained World Imports’ objection, holding that the risk of loss transferred to the debtor at the port when delivered to the shipper and therefore the goods were “constructively received” by the debtor when shipped from China. The bankruptcy court acknowledged that “received” was not defined in the Bankruptcy Code and held that state law (i.e. the Uniform Commercial Code (UCC)) did not control. Instead, the bankruptcy court looked to the Convention on Contracts for the International Sale of Goods (CISG), a treaty that governed disputes between the Chinese Suppliers and World Imports. The bankruptcy court held that the CISG preempted the UCC and then looked to international commercial terms, which are incorporated into the CISG, to hold that because the risk of loss passed to the buyer when the seller delivers goods to the common carrier under a FOB contract, the goods were “constructively received” by World Imports when the goods were shipped from China. The district court affirmed the bankruptcy court’s decision.

In overruling the lower courts, the Third Circuit looked to (i) the ordinary meaning of “received,” (ii) the legislative context for that and related words in certain sections of the Bankruptcy Code, and (iii) persuasive authority that Congress meant to import the UCC definition for “received” into section 503(b)(9). Based on these three findings, described below, the Third Circuit held that goods are “received” when a debtor takes physical possession of them.

Ordinary Meaning

The Third Circuit first reviewed the definition of “received” in Black’s Law Dictionary and the Oxford English Dictionary, both of which require physical possession of goods in order to “receive” them. The Third Circuit next reviewed UCC section 2-103(1)(c), which defines “receipt” of goods as “taking physical possession of them.” Given that this section of the UCC governed sales of goods within 49 states at the time section 503(b)(9) was enacted, the Third Circuit inferred that Congress meant to adopt this “well-known meaning” of the term (i.e. receipt requires physical possession).

Statutory Context

The Third Circuit first noted that section 503(b)(9) was enacted as part of BAPCPA in 2005 as an exemption to the general rule that sellers may reclaim goods from a debtor in certain circumstances as set forth in section 546(c) of the Bankruptcy Code. This interrelationship, according to the Third Circuit, required section 503(b)(9) be read and interpreted consistent with section 546(c). The Third Circuit also stated that the placement of both of these sections under the heading “Reclamation” in BAPCPA provided further support for its conclusion that the words of each statute should be interpreted consistently.

Persuasive Authority

The Third Circuit then turned to its pre-BAPCPA decision in In re Marin Motor Oil, 740 F.2d 220 (3d Cir. 1984), wherein the Third Circuit held that “receipt” in section 546(c) means the same thing as the UCC definition – taking “physical possession.” Because the use of “receipt” in section 546(c) and “received” in section 503(b)(9) are functionally equivalent and used in the same context, the Third Circuit held that UCC definition adopted in Marin Motor Oil must also apply to “received” in section 503(b)(9). This holding did not stand alone as the Third Circuit cited lower court decisions from the First, Third, Fourth, and Seventh Circuits, all of which held that terms in section 546(c) and 503(b)(9) must be interpreted consistently.

Not to be overlooked, the Third Circuit also held that goods are “received” by a debtor’s agent when such entity takes physical possession of those goods. Because the goods in World Imports were transported by a common carrier, not an agent, this holding did not alter the Third Circuit’s conclusion that World Imports took physical possession of the goods within the 20-day lookback period under section 503(b)(9).

In re SRC Liquidation, LLC, Case No. 15-10541 (BLS) (Bankr. D. Del. July 13, 2017).

SRC Liquidation, decided three days after World Imports, applied the holding of the Third Circuit case to a distinctly different factual scenario.

International Imaging Materials, Inc. (“IIMAK”) was a vendor to the debtor, Standard Register Company (n/k/a/ SRC Liquidation, LLC). IIMAK’s products were at times delivered directly to Standard Register and at other times delivered directly to the Standard Register’s end customers. In the latter situation, commonly referred to as drop shipping, IIMAK was directed by Standard Register to ship goods directly to their customers and IIMAK used Standard Register’s account with the United Parcel Service (UPS) to do so.

The parties’ dispute focused primarily on whether the value of the goods drop-shipped to Standard Register’s customers during the 20-day period prior to the petition date constituted administrative expense claims in favor of IIMAK. Standard Register argued that goods are only received by a debtor/buyer for purposes of section 503(b)(9) in certain situations – either actual physical possession or constructive receipt, relying on the examples in subsections (a)-(d) of UCC § 2-705(2).[1] IIMAK argued that courts should not narrowly construe the definition of “received” as new commercial realities, including a broad array of possible shipping procedures between sellers, debtors, and third parties, should be taken into consideration. Instead, IIMAK argued that the passing of title is the only way to provide a clear answer regarding when a debtor received goods.

The Delaware bankruptcy court, similar to the Third Circuit days before, reviewed the meaning of “received by the debtor” in section 503(b)(9), looked at the Uniform Commercial Code (UCC) for guidance on the meaning of “received,” and explored the relationship between sections 546(c) and 503(b)(9) and their common grounding in BAPCPA. The bankruptcy court then held that physical possession by the buyer or its agent (as interpreted in UCC § 2-705(2)), not the passing of title, is the appropriate indicator as to when a debtor “received” goods for purposes of section 503(b)(9).

Applying this holding to the facts of SRC Liquidation, the Delaware bankruptcy court denied IIMAK’s administrative expense claim because the goods were delivered by IIMAK to a common carrier (UPS) who then shipped the goods to Standard Register’s end customers. As Standard Register never possessed or received the goods, the bankruptcy court held that IIMAK had no valid section 503(b)(9) claim.

Why these Cases are Interesting

Over 20 retailers, including household names such as Gymboree, rue21, Payless, BCBG Max Azria, The Limited, Wet Seal, and True Religion, have filed for chapter 11 bankruptcy in the first half of 2017. Although many of these cases were filed in jurisdictions outside the Third Circuit, the decisions in World Imports and SRC Liquidation will undoubtedly have a significant impact across the country.

For example, the Third Circuit in World Imports cited lower court decisions in the First, Fourth, and Seventh Circuits for the proposition that “received” in sections 503(b)(9) and 546(c) should be given the same meaning. It is likely that lower courts in these circuits will adopt the reasoning and holdings of World Imports, especially in light of existing persuasive jurisprudence on the subject. A second, more obvious example, relates to the broad impact these decisions have on suppliers who service retailers’ e-commerce platforms or ship their products directly to a retailers’ customers. The supplier in SRC Liquidation raised this concern when they noted that a “received” equals “physical possession” rule does not comport with how businesses operate in today’s global, interconnected marketplace. This observation is true today and will likely become more entrenched as time goes on. These two decisions also have drastically different outcomes although based on a concept of physical possession. The supplier in World Imports benefitted from the delayed time period resulting in “receipt” whereas the vendor in SRC Liquidation would never get the benefit of priority status since the debtor never physically obtained the goods under a direct/drop ship delivery method.

As a result, suppliers, vendors, merchants, and lenders need to pay careful attention to how goods are delivered to see if there are opportunities (World Imports) or impediments (SRC Liquidation) to administrative priority claim status – matters that become more complicated as retail logistics and delivery methods evolve with the manner in which consumers purchase goods. (Of course, these decisions are not limited to retailers, but are timely given the current restructuring environment.)