In the first part of this article, we considered the effect of section 365(d)(4) and other Bankruptcy Code sections on retailer debtors and their respective landlords, as well as on how retailer debtors can utilize the holiday sales season to implement a successful reorganization. This second part of the article examines the recent developments affecting vendors involved in retailer bankruptcies, including the limitation of critical vendor motions, the amended reclamation power under section 546(c), the introduction of section 503(b)(9) administrative priority claims, and the ability of a retailer debtor to return goods to a vendor under section 546(h). In addition, this part II discusses the current state of DIP financing in retailer bankruptcies, the deference courts grant to state laws governing "Going Out of Business" ("GOB") sales, and the need for vendors to determine what goods they may in fact have the ability to liquidate.

V. Products to Sell: The Treatment of Vendors.

A retailer's business plan is all about selling products to customers. Without products to sell, there is no retail business to reorganize (or liquidate, either). The treatment of vendors becomes a key concern in any retailer's bankruptcy case.

Critical Vendors

Starting in the mid-1990's, payment of prepetition claims to particular "critical vendors" was a de rigueur first day motion in retailer cases, as well as manufacturing and other supplier-dependent cases. In recent years, however, this practice has come under attack by academics, judges, and practitioners. Critics point out that the critical vendor concept was never codified in the Bankruptcy Code, and the practice had become so widely used that it had evolved into a "desired vendor" order rather than one covering truly critical vendors. The Seventh Circuit Court of Appeals and the Bankruptcy Court for the Northern District of Texas addressed this issue in In re Kmart Corp.24 and In re CoServ, L.L.C.,25 respectively, and sharply curtailed the procedure.

In In re Kmart, the court challenged the existence of a "critical vendor" under the Bankruptcy Code and questioned whether there was even a place for critical vendors in the bankruptcy process.26 The court set a high bar for critical vendor payments, requiring a showing that payment to the particular "critical vendor" would benefit not just that vendor, but the debtor's other creditors, too.27 The practice was similarly discouraged in In re CoServ. In that case, the court required that, before the debtor is authorized to pay a vendor's prepetition debt, the debtor establish: (i) it is critical to the estate for the debtor to purchase goods from the vendor; (ii) if the debtor cannot pay the claimant, the debtor will suffer harm or damage to its going concern value disproportionate to the claimant's prepetition claim; and (iii) the debtor has no practical or legal alternative other than to pay the debt.28

Whether critical vendor payments will be approved in the post-Kmart era may depend on the jurisdiction involved. While it is easier for a debtor to obtain critical vendor authority in the Second and Third Circuits, and remains possible in the Seventh Circuit, the Fifth and Ninth Circuits do not, as a rule, grant critical vendor motions.29

Reclamation

Although Kmart and CoServ made it more difficult for creditors to have their prepetition claims paid postpetition as "critical vendors," BAPCPA's amendment of reclamation procedures provides some additional protections for vendors who delivered goods to debtors prepetition.

Under section 546(c) of the Bankruptcy Code, a vendor may reclaim goods received by the debtor within the 45 days prior to the commencement of the case, provided that the vendor serves a notice within 20 days after the commencement of the case.30

In analyzing those reclamation rights, section 546(c) explicitly directs that the vendor's ability to reclaim goods is subject to the prior rights of a secured lender with a lien on the goods or the proceeds of the goods. This language essentially codifies the "prior lien" defense that had been recognized by some courts pre-BAPCPA.31 This defense, recognized in In re Dairy Mart Convenience Stores, Inc.,32 may limit the utility of the expanded reclamation rights. That is, although the reclamation window has been expanded from 10 days to 45 days, the vendor may find there is little practical benefit to pursue those rights because it is difficult to imagine that goods delivered prepetition would not have been encumbered upon delivery, particularly given the prevalence of inventory and other secured financing in the retail world.

A recent decision in the bankruptcy case of Circuit City Stores, Inc. illustrates how ineffective section 546(c) can be as a remedy for vendors.33 When Circuit City filed for bankruptcy, certain of its vendors made reclamation demands, but they did not pursue their claims at the commencement of the case. To do so would have been pointless because those goods were also subject to the prior rights of the prepetition secured lender.34 After Circuit City's inventory had been liquidated and the prior liens of its secured lenders satisfied, the vendors tried to assert their reclamation claims, arguing that: (i) their reclamation claims had survived as liens attaching to the proceeds of the reclamation goods; or (ii) they should be entitled to administrative priority because the court had failed to adequately protect their interests.35 The bankruptcy court rejected both arguments. According to the court, section 546(c) grants a vendor only a limited right to assert a state law reclamation claim for the return of the goods themselves and does not extend to proceeds. Moreover, the court found no statutory basis for granting an administrative claim to a reclaiming creditor whose goods had been sold by the debtor, beyond that provided by section 503(b)(9), as discussed below.36

Section 503(b)(9) Claims

Congress also introduced an entirely new vendor claim in the BAPCPA revisions. Section 503(b)(9) provides an administrative priority to claims for "the value of any goods received by the debtor within the 20 days" prior to the commencement of the case.37 As with reclamation, this right applies to goods, not services, even though section 503(b)(9) priority is for the value of the goods and not a right to the return of the goods themselves.38

As administrative expenses, these claims will need to be paid in full in order for the debtor to confirm a chapter 11 plan. This creates a new opportunity for debtors to negotiate with their vendors by obtaining authority to pay section 503(b)(9) claims during the case, instead of at confirmation, in exchange for concessions from the vendor.39 No reported cases thus far have compelled a debtor to pay 503(b)(9) claims any earlier than confirmation, and courts have denied or deferred ruling on creditors' attempts to force earlier payment. Still, knowing that their claims will need to be paid before the debtor can emerge from bankruptcy should provide some comfort to the vendors.

It is noteworthy that the court administering Circuit City's bankruptcy case has consistently interpreted section 503(b)(9) narrowly, so as to limit the sorts of vendor claims given administrative priority. First, the court adopted the UCC definition of "goods" and the "predominant purpose" test for determining whether "goods have been sold to the debtor" within the meaning of section 503(b)(9).40 The effect of the ruling was to disallow any section 503(b)(9) administrative priority claim for the value of goods delivered to Circuit City under a contract, the predominant purpose of which was the provision of services. In so holding, the bankruptcy court rejected the In re Plastech Engineered Products, Inc.41 decision.42 In Plastech, the court refused to apply the primary purpose test and concluded that a section 503(b)(9) claim should be allowed for any goods delivered to the debtor, even if incidental to the provision of services.43

Second, the Circuit City court held that goods were "received", within the meaning of section 503(b)(9), when Circuit City took physical possession of them.44 A vendor had physically delivered goods to Circuit City more than 20 days before Circuit City filed for bankruptcy. The vendor argued that, under the terms of the parties' consignment agreement, title to the goods did not pass to Circuit City until they were sold to customers - which allegedly occurred within section 503(b)(9)'s 20-day window - and that the goods were not "received" within the meaning of section 503(b)(9) until title passed to Circuit City.45 The bankruptcy court rejected this argument, citing definitions of the words "received" and "receipt" that have been adopted by courts interpreting the UCC and other sections of the Bankruptcy Code, and held that "received" means "having taken into physical possession."46

Third, the Circuit City court held that section 502(d), which temporarily bars claims asserted by recipients of voidable transfers, applies to section 503(b)(9) claims.47 As a result, a vendor cannot compel payment on its 503(b)(9) claim until it has returned any preferences or other avoidable transfers to the estate. In so holding, the court distinguished ASM Capital, LP v. Ames Dep't Stores, Inc. (In re Ames Dep't Stores, Inc.),48 where the Second Circuit concluded that section 502(d) did not apply to section 503(b) administrative expenses.49 The Circuit City court found it significant that section 503(b)(9) claims, unlike the section 503(b) administrative expenses that were at issue in Ames, arise prepetition and are thus held by creditors who must file proofs of claim under section 501(a) - claims which may be disallowed under section 502(d).50 Therefore, the court concluded "that § 502(d) may be used to temporarily disallow § 503(b)(9) claims."51

Moreover, the narrow interpretation of section 503(b)(9) was recently taken a step further by the Bankruptcy Court for the District of Delaware in In re Goody's Family Clothing, Inc.52 In pertinent part, the Goody's court held that goods must actually be sold to the debtor in order for a 503(b)(9) claim to arise. Merely contributing value to goods received by the debtor is insufficient.53 In Goody's Family Clothing, a vendor asserted a 503(b)(9) claim for inspection, unpacking, ticketing, assorting, and repackaging of garments that the debtor had purchased from another vendor, on the basis that those services added to the garments' value. Since the basis for its claim was services that contributed to the "value of goods" received by the debtor, the vendor argued that section 503(b)(9) granted it administrative priority status because its services contributed to the "value of goods."54 The court rejected this argument, finding that Congress intended section 503(b)(9) to prioritize claims for goods sold, not services provided. Thus, the court held that because the vendor never had title to the garments, it could not have sold them, and the vendor's services that contributed to the goods' value was insufficient to generate a 503(b)(9) claim.55

Return of Goods

Section 546(h) of the Bankruptcy Code permits debtors to return goods to vendors under certain circumstances.56 A retailer debtor frequently incurs costs storing and insuring goods that it is currently unable to sell. Debtors also frequently have inventory that is simply no longer saleable, having become obsolete or outdated.

Section 546(h) permits a debtor to return goods to a creditor who shipped the goods to the debtor prepetition for an offset against that creditor's prepetition claim. The court may approve a return of goods if it is in the best interests of the estate. The motion for authority to effect a return of goods must be made by the debtor, within 120 days of the commencement of the case, and with the consent of the creditor to whom the goods are to be returned. It is only available to debtors in chapter 11 cases. And, as with the reclamation provisions, the right is "subject to the prior rights of holders of security interests in such goods or the proceeds of such goods."57

The only reported decision on section 546(h) is In re Century Electronics Manufacturing Inc.58 In that case, the debtor sought authority to return goods to a prepetition trade vendor in exchange for cash and an offset against the debt owed to that creditor. A secured creditor with a first-priority lien on the goods objected, arguing that the proposed return was a conversion of its property for less than fair value. The creditors' committee also objected, arguing that the proposed return amounted to preferential treatment of the trade creditor and expressing a concern that if the court granted the motion the secured creditor would request relief from the automatic stay for lack of adequate protection, possibly resulting in a super-priority administrative claim or conversion of the case.59 However, before a further hearing on the debtor's motion, the interested parties entered into a stipulation that resolved their disputes.60 In considering whether to permit the return of goods, had the stipulation not been executed, the court held that if the return was solely in exchange for the reduction of an unsecured claim, the return would not be in the best interests of the estate as required by section 546(h).61 The stipulation proposed in Century Electronics, however, provided additional benefits to the estate by "staving off" the objecting secured creditor through the provision of adequate protection and compelling the trade vendor to direct orders to the debtor and thus add assets to the estate. Given these additional benefits, and in the absence of any remaining objections, the court held that the return of the goods was in the estate's best interests.62

To benefit from a return of goods under section 546(h), the vendor must work quickly to persuade the debtor to file a motion - the statute requires the motion be filed by the debtor within 120 days. Then, the court must be persuaded that the proposed return is in the best interests of the estate. In Century Electronics, the court held that the vendor cannot satisfy this requirement simply by demonstrating a reduction in the claims pool as a result of the return.

Going forward, the return of goods may only be an option if there is no creditor with a security interest in the goods, or any secured creditor either consents or is so over-secured that the loss of these items from its collateral is immaterial. The very specific, and unusual, factual requirements may explain the dearth of case law on a provision that has been in the Bankruptcy Code for nearly 15 years. Nonetheless, under the right circumstances, section 546(h) could be a potentially useful tool for retailer debtors to manage their relationship with their vendors.

VI. End Game: DIP Financing and the Exit Strategy.

In a "normal" economic environment, a struggling retailer would look for DIP financing to enable it to file for chapter 11, sort out its business and financial issues, and emerge on the other side as a healthy, reorganized company. With the accelerated timetable imposed by section 365(d)(4), the decreased appetite for risk by lenders, and the constriction in consumer spending, the options for retailer debtors are likely more restrictive today.

DIP financing for the retailer debtor now is often little more than funding to complete a GOB sale. Therefore, the most likely source of funding is the retailer's current lenders, who are essentially making protective advances to liquidate their prepetition collateral under the protection of chapter 11. GOB sales are governed by statutes or regulations in most states, and an immediate question is whether the bankruptcy court can override those state restrictions in order to maximize value to the estate.

Section 959(b) of Title 28 provides that the debtor "shall manage and operate the property in [its] possession . . . according to the requirements of the valid laws of the State in which such property is situated, in the same manner that the owner or possessor thereof would be bound to do if in possession thereof."63 The only exception to this rule is section 1166 of the Bankruptcy Code, which provides certain limited exceptions for railroad reorganizations. However, there is also a long line of case law stating that the Bankruptcy Code preempts contrary state law.64

In In re Willis Furniture Co.,65 the debtor and the liquidator attempted to skirt state consumer protection law governing GOB sales by requesting the permission of the court to supplement the debtor's inventory with additional items supplied by the liquidator, which would have violated Massachusetts' GOB sales regulations. The court found that it was inconsistent with the purposes and policies underlying the Bankruptcy Code for the court to assist a third party in profiting from the debtor's financial trouble or to aid a party in misleading the public (which the proposed augmenting of the inventory arguably would do).66

The court in In re Lauriat's Inc.67 faced the same issue. In that case, the debtor sought to be exempted from certain provisions of a state law regarding GOB sales, arguing that only through noncompliance with state law could it maximize recovery for the estate from the assets of the stores to be closed. The court denied the motion, reasoning that it could not carve an unwritten exemption for debtors out of the language of 28 U.S.C. § 959, and that it lacked the discretion to authorize a GOB sale in contravention of state law. Rather, the debtor was required to manage the estate property in accordance with such laws, with no exception for convenience or monetary gain.

Courts in some other jurisdictions, including the District of Delaware and the Southern District of New York, have historically been more liberal in their willingness to approve GOB sales that conflict with - or at least are not expressly compliant with - state laws and regulations. However, several recent decisions in the District of Delaware have shown an increasing willingness to allow state regulators to have oversight of GOB sales.68

Finally, as the struggling retailer is being liquidated, an issue may arise as to whether the retailer can in fact sell all the goods in its possession. For example, in In re Whitehall Jewelers Holdings, Inc.,69 the court assessed whether it was permissible to sell inventory held on consignment in a sale under section 363 of the Bankruptcy Code.70 The debtors argued that section 363(f)(4) of the Bankruptcy Code provided a sufficient basis to permit the sale, on the ground that the claimants' interests in the consigned goods was subject to a "bona fide dispute" within the meaning of section 363(f)(4). However, the court concluded that the debtors had ignored the threshold issue of whether the consigned goods were property of the estate and refused to permit the sale until the rights of the parties to the consigned goods had been determined.71

VII. Conclusion.

The bankruptcy process moves quickly, and in today's environment, retailer bankruptcies are moving even quicker. In light of BAPCPA's changes, and the difficulties debtors face securing financing, it is critical for a retailer debtor to have a plan negotiated, or at least outlined, prior to the petition date. Communication between the debtor and its creditors prior to the commencement of proceedings is also beneficial to the debtor in the long run, as the renegotiation of leases and executory contracts is more likely to succeed if the creditors feel that they have an active voice in the process. The debtor and its advisors should have a solid idea of how long the company is expected to be in bankruptcy, what the exit plan ultimately is, and the time of year during which the bankruptcy process will take place. Taking these steps will enable the retailer debtor to move more quickly and efficiently through the bankruptcy process, hopefully emerging as a successfully reorganized company or at least returning the greatest possible value to its creditors.

* A prior version of this article was presented at the Boston Bar Association's 19th Annual Bankruptcy Bench Meets Bar Conference in May, 2009. The authors gratefully acknowledge the assistance of Sarah L. McGarrell with the preparation of that article.