Creditors lacking liens to secure their claim can fare poorly in a bankruptcy case. The “absolute priority rule” is a bedrock principle of bankruptcy law and provides that a creditor at a particular rung of the claim priority hierarchy must be paid in full before any money flows down to junior creditors. Secured creditors reside near the top of the hierarchy, followed by administrative expense claimants, priority claimants and general unsecured creditors. In many cases, there is insufficient money to pay secured creditors in full, thus leaving general unsecured creditors with no recovery at all. In other cases, the funds flowing to general unsecured creditors are sufficient to pay only pennies on the dollar. Because of this dynamic, creditors are incentivized to argue that their claim should be classified as high up the hierarchy as possible. There are, however, exceptions to the claim hierarchy rules. Bankruptcy Code section 503(b)(9) provides an administrative expense claim to vendors for the value of goods they delivered to the debtor within 20 days prior to the bankruptcy filing. The case In re SRC Liquidation, LLC, decided in July 2017 by the Bankruptcy Court for the District of Delaware, makes clear that section 503(b)(9) claim rights will be strictly construed to goods that are physically provided to the debtor.

In order for any Chapter 11 plan to be confirmed, administrative expense claims must be paid in cash in full. Generally speaking, administrative expense claims are claims related directly to administering the bankruptcy case. Examples include fees payable to the United States Trustee and fees payable to professionals such as debtor counsel and creditor committee counsel. However, Congress has also used administrative expense claims as a tool for pulling certain types of unsecured claims to the top of the claim hierarchy. This includes section 503(b)(9) claims. Unless otherwise ordered by the court, suppliers of the applicable 20-day goods are not required to file a notice or to take any other action. Rather, they automatically are entitled to be paid in full for such 503(b)(9) claims.

The prospect of paying in full in cash for all 20-day goods can be daunting for a cash poor debtor. This is especially the case for large retailers where the total amount owed on account of such goods can be a very large amount. In addition, paying 503(b)(9) claims in full may mean that there is much less available to pay other creditors. Therefore, both the debtor and other parties in interest may be highly motivated to argue that certain creditors asserting 503(b)(9) claims do not, in fact, qualify under the statute. These dynamics were squarely in play in the SRC Liquidation case. The case involved a debtor who had purchased goods from vendor International Imaging Materials, Inc. (“IIMAK”). In the ordinary course of the debtor and IIMAK’s business, IIMAK would ship certain goods directly to the debtor, and would “drop ship” other goods by sending them directly to the debtor’s customers. The dropped shipped goods were sent via common carrier UPS.

IIMAK asserted that it was entitled to a 503(b)(9) administrative expense claim for all goods shipping within 20 days prior to the debtor filing bankruptcy. Another party in the case, Standard Register, Inc. (“SRI”) argued that the $44,439.78 worth of drop shipped goods did not qualify under section 503(b)(9) because the debtor never actually took possession of the goods. In other words, the good were not “delivered to” the debtor, as that term is used in the statute. IIMAK argued in response that the debtor was in constructive receipt of the goods and also that the court should consider issues related to when title to the goods passed, rather than whether or not a debtor took physical possession.

The court began its analysis by noting that administrative claims such as 503(b)(9) claims are “discrete exceptions to the general equality principal” that similarly situated creditors (i.e., unsecured creditors) should be treated the same. Because these claims are exceptions to the general rule, the court reasoned, they must be “strictly construed and be clearly authorized by Congress.” The court noted that section 503(b)(9) claims were created in 2005 by the Bankruptcy Abuse Prevent and Consumer Protection Act, in conjunction with amendments to reclamation rights under section 546(c). Thus, the concept of whether goods are “received” for the purposes of reclamation bears directly on the same issue for section 503(b)(9) claims. Reclamation, in turn, is based on Article 2 of the Uniform Commercial Code; specifically, U.C.C. § 2-705(2). The court noted that the well-accepted view under the U.C.C. is that goods must be in a party’s physical possession to be received. For the same reason, the court held that passage of title was not relevant. The court stated that “the U.C.C. does not rely on the concept of title for the purposes of establishing rights of buyers and sellers: possession is the key.” Finally, the court analyzed whether providing the goods to a common carrier could be considered passage to the debtor under the argument that the common carrier was the debtor’s agent. The court did not accept that argument given prior Third Circuit law that common carriers cannot qualify as debtor agents for the purposes of section 503(b)(9).

Section 503(b)(9) claims, like reclamation claims, are designed in part to provide assurances to vendors in an attempt to prevent a bankruptcy filing in the first place. That is, if a vendor has some degree of assurance that it will be paid, the vendor may not take drastic action such as requiring its customer to make payment in advance of shipping the goods. Alternatively, without such assurances, financially troubled companies would be driven quickly into bankruptcy by vendors who refuse to extend any credit. The SRC Liquidation case provides some additional guidance to vendors on when they will, and when they will not, be entitled to the protection of administrative expense priority. Clearly, concerned vendors should be wary of drop shipment. In addition, if it is commercially unreasonable to avoid drop shipments, a vendor might consider exploring the use of a private (rather than common) carrier who could legitimately be considered an agent of the debtor. Being aware of this issue, and taking proactive steps, could make a significant difference between being paid in full versus being left with little to no recovery.