The Sixth Circuit recently held that section 2-702(3) of the Uniform Commercial Code (the "UCC"), which permits good faith purchasers to defeat a valid right to reclaim, does not allow a secured creditor to defeat that right.[1] The Sixth Circuit found that the security interest held by a DIP lender could not be used to defeat the right of a reclaiming creditor under the UCC or pre-BAPCPA section 546(c) of the Bankruptcy Code. This decision may impact the way bankruptcy courts consider reclamation claims under revised section 546(c) of the Bankruptcy Code.

Factual Background

Phar-Mor filed a voluntary petition for relief under chapter 11 of the Bankruptcy Code on September 24, 2001 (the "Petition Date"). Six days before the Petition Date, McKesson sent a demand letter to Phar-Mor asserting the right to reclaim approximately $8.5 million worth of goods delivered to Phar-Mor by McKesson. Approximately 140 other vendors sent reclamation demand letters to Phar-Mor prior to and after the Petition Date.

On the Petition Date, Phar-Mor owed its secured creditors approximately $103.5 million. The Bankruptcy Court entered interim and final orders, effective as of the Petition Date, authorizing Phar-Mor to borrow up to approximately $135 million. These DIP loans were secured by superpriority claims and senior liens on substantially all of Phar-Mor's assets. The DIP loan was used to repay Phar-Mor's prepetition secured creditors, which extinguished the security interests held by such creditors. The security interests of the prepetition secured creditors were not assigned or transferred to the DIP lender under either the interim or final DIP orders.

Phar-Mor liquidated its assets in bankruptcy. After Phar-Mor closed its stores and conducted going-out-of-business sales, Phar-Mor moved the Bankruptcy Court for the entry of an order classifying all reclamation claims asserted against Phar-Mor's estate as general unsecured claims. Phar-Mor asserted that the goods subject to reclamation demands, including the goods delivered by McKesson, had been sold and the proceeds used to pay off the DIP lender, thereby extinguishing the vendors' rights to reclaim such goods under applicable law. On this basis, Phar-Mor argued that all reclamation claims should be classified as general unsecured claims.

The Bankruptcy Court, through a series of opinions,[2] concluded that the reclamation claims asserted before the Petition Date were valid. The Bankruptcy Court reasoned that these reclamation claims could not be extinguished by the security interest held by the DIP lender since such security interest arose after such reclamation claims were asserted, thus preventing the DIP lender from qualifying as a "good faith purchaser" as to such goods under section 2-702(3) of the UCC. The Bankruptcy Court found that the reclamation claims asserted after the DIP lender's security interest arose were subject to the DIP lender's security interest and, thus, should be reclassified as general unsecured claims. Because McKesson's reclamation demand was received before the Petition Date, the Bankruptcy Court held that McKesson was entitled to an administrative expense priority claim under section 546(c) of the Bankruptcy Code. Phar-Mor appealed the Bankruptcy Court's decision.

The Sixth Circuit's Opinion

The Sixth Circuit affirmed the Bankruptcy Court's decision to grant McKesson an administrative expense priority claim equal to the value of the goods that McKesson had the right to reclaim under the UCC. The Sixth Circuit reasoned that Phar-Mor did not obtain an ownership interest in goods subject to valid reclamation claims because the goods were obtained as if by fraud, i.e. , Phar-Mor's implicit representation of solvency when it ordered the goods. For this reason, Phar-Mor did not have an interest in such goods to which a security interest could attach. On this basis, the Sixth Circuit found that McKesson had the right to reclaim the goods delivered to Phar-Mor and that such right was superior to any right of an attaching creditor, including a secured creditor.

According to the Sixth Circuit, "UCC 2-702(2) grants a properly reclaiming vendor, such as McKesson, a right to reclaim its goods and that UCC 2-702(3) does not allow a secured creditor's claim to defeat that right." The Sixth Circuit further held that because the rights of a reclaiming vendor are not subject to the rights of a secured creditor, the Bankruptcy Court could only deny reclamation under section 546(c) of the Bankruptcy Code if it granted "the denied vendor either an administrative-expense priority in the amount of the goods or a lien on the proceeds resulting from the use of those goods by the debtor." In the case of McKesson, the Bankruptcy Court granted McKesson an administrative expense priority claim. Accordingly, the Sixth Circuit found no basis to overturn the Bankruptcy Court's decision.

The Sixth Circuit decision arguably went beyond the Bankruptcy Court's ruling that the DIP lender did not qualify as a "good faith purchaser" as to those goods that were subject to formal reclamation demands made before the Petition Date or the date that the DIP lender's security interest arose. The Bankruptcy Court considered McKesson's reclamation claim valid because it arose before the DIP lender's security interest. The Sixth Circuit decision, however, could be interpreted to require bankruptcy courts to grant reclamation creditors either an administrative expense priority claim or a replacement lien irrespective of whether the goods in question are subject to a pre-existing security interest.

If a security interest cannot attach to goods that could be reclaimed under the UCC on the basis of fraud, then the goods received by Phar-Mor that were the subject of post-DIP order reclamation demands could not have constituted collateral under Phar-Mor's DIP facility because Phar-Mor never acquired any rights in such goods to which a security interest could attach. This issue, however, was not before the Sixth Circuit because none of the holders of reclamation claims that were classified as general unsecured claims on account of the DIP lender's security interest appealed the Bankruptcy Court's decision to the Sixth Circuit.

It is not clear how this decision will impact cases decided under new section 546(c) of the Bankruptcy Code. The Sixth Circuit's decision was decided under pre-BAPCPA section 546(c) of the Bankruptcy Code, which made the rights of a debtor in possession subject to "any statutory or common-law right of a seller of goods . . . to reclaim such goods." Courts generally interpreted this to refer to section 2-702 of the UCC, which provides a statutory right to reclaim goods "subject to the rights of a buyer in ordinary course or other good faith purchaser." New section 546(c) expressly provides that the right to reclaim is "subject to the prior rights of a holder of a security interest in such goods or the proceeds thereof." Accordingly, it may now be the case that reclamation creditors cannot be defeated by the rights of prior secured creditors under non-bankruptcy law (because secured creditors are not "good faith purchasers" under section 2-702 of the UCC), but can be so defeated in bankruptcy (because such claims are expressly subject to the "prior rights of a holder of a security interest"). Conversely, if a security interest cannot attach to goods subject to reclamation claims under state law, it may be that a security interest cannot attach to such goods in bankruptcy, irrespective of new section 546(c) of the Bankruptcy Code.

Section 503(b)(9) of the Bankruptcy Code, which automatically accords administrative expense priority status to goods delivered within 20 days of the petition date, may eliminate this controversy since the UCC only permits a vendor to reclaim goods upon demand made within 10 days after receipt, unless a prior representation of solvency has been made. The legal arguments adopted by the Sixth Circuit, however, are likely to generate more litigation over reclamation claims, specifically the validity of security interests in goods subject to reclamation claims and whether the Sixth Circuit's decision is applicable to new section 546(c) of the Bankruptcy Code. Given the increased number of retailers and manufacturers seeking relief under the Bankruptcy Code, this decision merits careful consideration by all parties involved in business restructurings.