United States: To Have And To Hold: Third Circuit Rules That Physical Possession Of Goods Is Required Under Section 503(b)(9) Of The Bankruptcy Code

Last Updated: November 24 2017
Article by Danielle Barav-Johnson

Since its enactment as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, section 503(b)(9) of the Bankruptcy Code has provided an important safety net for creditors selling goods to financially struggling companies that file for bankruptcy. The provision gives vendors an administrative expense priority claim for the value of goods "received by the debtor" during the 20-day period before the bankruptcy petition date. The U.S. Court of Appeals for the Third Circuit recently considered section 503(b)(9) and its relationship with another important vendor protection—reclamation rights under section 546 of the Bankruptcy Code and related nonbankruptcy law—in In re World Imports, Ltd., 862 F.3d 338 (3d Cir. 2017). The Third Circuit reversed lower court rulings that the phrase "received by the debtor" in section 503(b)(9) includes constructive possession of goods at the time title is transferred, in addition to physical possession of the goods.

Section 503(b)(9) Claims and Reclamation Rights

Section 503(b)(9) provides that a creditor shall have an administrative expense claim for "the value of any goods received by the debtor within 20 days before the date of commencement of a [bankruptcy] case . . . in which the goods have been sold to the debtor in the ordinary course of such debtor's business." Administrative expense priority is a benefit to creditors and a burden to debtors. Unless the creditor agrees otherwise, the debtor cannot confirm a chapter 11 plan without paying administrative claims in full. See 11 U.S.C. § 1129(a)(9)(A). By contrast, vendor claims that do not meet the requirements of section 503(b)(9) typically are treated as general unsecured claims, entitling the holders to no more than their pro rata share of the estate's unencumbered assets.

Section 503(b)(9) works in tandem with a seller's "reclamation" rights under applicable nonbankruptcy law. Section 546(c) of the Bankruptcy Code provides that, with certain exceptions, the avoidance powers of a trustee or chapter 11 debtor-in-possession are subject to the right of a vendor who sold goods to a debtor in the ordinary course of the vendor's business to "reclaim" those goods from the debtor, including by stopping shipment of or retrieving the goods, "if the debtor has received such goods while insolvent" and within 45 days before filing for bankruptcy, provided that the vendor timely gives notice of the reclamation. Section 546(c)(2) explicitly provides that a seller failing to timely give such notice may nonetheless "assert the rights contained in section 503(b)(9)." Thus, the applicability of both provisions hinges in part on when a debtor receives the applicable goods.

In World Imports, the Third Circuit examined the meaning of "received" under section 503(b)(9) as a matter of first impression in the circuit courts of appeal.

World Imports

World Imports, Ltd. (the "debtor") purchased furniture and other goods from two international vendors. The vendors shipped the goods to the debtor by common carrier more than 20 days before it filed for chapter 11 protection on July 3, 2013, in the Eastern District of Pennsylvania. Certain of the goods were shipped directly ("drop-shipped") to the debtor's customers, while others were shipped directly to the debtor. In each case, the goods were shipped "free on board" ("FOB") at the port of origin, meaning that title to the goods and the risk of loss passed to the debtor at the port. All of the goods were received by either the debtor or its customers within the 20-day period prior to the debtor's bankruptcy filing.

The vendors asserted administrative expense claims under section 503(b)(9), arguing that the goods were "received" when they were delivered to the debtor or its customers. The debtor countered that it "received" the goods for purposes of section 503(b)(9) when title to the goods transferred to the debtor upon shipment FOB—prior to the 20-day window.

Because the term "received" is not defined in the Bankruptcy Code, the debtor and the vendors insisted that the definition must be drawn from nonbankruptcy law, but they disagreed on the appropriate source of law. The vendors argued that the definitional "gap" should be filled by state law—specifically, the Uniform Commercial Code (the "UCC"). The debtor maintained that the definition should be drawn from the law governing the sale transaction, which in this case was the Convention on Contracts for the International Sale of Goods (the "CISG") and the international commercial terms ("incoterms") incorporated therein.

The bankruptcy court held that, as an international treaty, the CISG preempts application of the UCC and provides the meaning of undefined terms for transactions which fall under its purview. Although the CISG and the incoterms do not directly define the term "received," the court explained, the incoterms provide that goods shipped FOB are delivered by the seller when placed on board a common carrier for shipment. As a result, the bankruptcy court found that all goods were constructively received by the debtor when they were shipped FOB more than 20 days prior to the bankruptcy petition, except for the drop-shipped goods, which were never received by the debtor. Therefore, the court ruled that the vendors were not entitled to a section 503(b)(9) claim for the value of the goods.

The district court affirmed on appeal, and the vendors appealed to the Third Circuit.

The Third Circuit's Ruling

A three-judge panel of the Third Circuit reversed. The panel held, among other things, that the UCC is the proper source of law to fill in the gaps of undefined terms in section 503(b)(9), regardless of whether the CISG otherwise governed the transaction.

The Third Circuit noted the presumption that an undefined statutory term incorporates the ordinary meaning of the term which was in use when the statute was enacted, if there was one. After consulting several dictionaries, the panel concluded that the legal and dictionary definitions of "received" all require physical, as distinguished from constructive, possession. Moreover, the Third Circuit explained, Article 2 of the UCC, which defines "receipt" of goods as "taking physical possession of them" (see UCC § 2-103(1)(c)), governed the sale of goods in 49 states when section 503(b)(9) was enacted, and the legislative history indicates that Congress relied on the UCC definition for the term "received."

Because section 546(c) of the Bankruptcy Code (governing reclamation) was designed to function in conjunction with section 503(b)(9), the Third Circuit panel examined the meaning of "received" under section 546(c), reasoning that a consistent definition of the term must apply to each provision. The Third Circuit had previously ruled in Montello Oil Corp. Cities Service Co. v. Marin Motor Oil, Inc. (In re Marin Motor Oil, Inc.), 740 F.2d 220 (3d. Cir. 1984), that Congress intended to incorporate the UCC's reclamation provision (UCC § 2-702) into the Bankruptcy Code when it enacted section 546(c) in 1978 and, therefore, that the provision incorporates the UCC definition of "receipt." Adopting that reasoning, the Third Circuit panel in World Imports concluded that section 503(b)(9) must incorporate the same UCC definition.

Notably, the Third Circuit held that the definitional gap in section 503(b)(9) is not to be filled by reference to applicable law on a case-by-case basis. The court determined instead that Congress incorporated the UCC definition of "receipt" into section 503(b)(9) upon its enactment as a static definition. In other words, the Third Circuit panel explained, the meaning of "received" is not drawn from applicable law governing the relevant transaction, but rather is consistent regardless of the terms of the underlying transaction.

The Third Circuit rejected the debtor's argument that the goods were constructively "received" more than 20 days prior to the bankruptcy filing when they were delivered FOB to a common carrier, at which point both title and the risk of loss passed to the debtor. The court ruled that neither transfer of title nor the risk of loss amounts to constructive receipt of goods. Furthermore, the court noted, although physical receipt of goods by an agent of the buyer constitutes constructive receipt for purposes of section 503(b)(9), Third Circuit case law has consistently held that common carriers do not qualify as agents under section 503(b)(9) or the UCC.

The court ruled that, because the debtor physically received the goods which were not drop-shipped within 20 days of filing for bankruptcy, the vendors were entitled to an administrative expense claim for the value of those goods delivered to the debtor.

Ramifications of World Imports: In re SRC Liquidation, LLC

World Imports is significant as the first circuit court decision to address whether physical possession is required for goods to be "received" under section 503(b)(9). However, the Third Circuit was not the first court to consider the issue. Several other courts have similarly held that a section 503(b)(9) claim requires physical possession of goods by the debtor or its agent within the 20-day prepetition window. See, e.g., In re Wezbra Dairy, LLC, 493 B.R. 768 (Bankr. N.D. Ind. 2013) (holding that goods are "received" under section 503(b)(9) when they come into the debtor's physical possession, rather than when title to the goods transfers to the debtor); In re Circuit City Stores, Inc., 432 B.R. 225 (Bankr. E.D. Va. 2010) (same). It remains to be seen whether other courts not bound by the Third Circuit precedent will also adopt this approach.

Although the Third Circuit did not address the issue, World Imports is likely to impact administrative expense claims for goods that have been drop-shipped. Like several other courts that have considered the matter (see, e.g., Ningbo Chenglu Paper Prod. Mfg. Co. v. Momenta, Inc., 2012 WL 3765171 (D.N.H. Aug. 29, 2012); In re ADI Liquidation, Inc., 2017 WL 2712287 (Bankr. D. Del. June 22, 2017); In re Momenta, Inc., 455 B.R. 353, 361 (Bankr. D.N.H. 2011)), the bankruptcy court in World Imports held that drop-shipped goods were not "received" by the debtor for purposes of section 503(b)(9). See In re World Imports, Ltd., 511 B.R. 738, 740 n.2 (Bankr. E.D. Pa. 2014), aff'd, 549 B.R. 820 (E.D. Pa. 2016), rev'd, 862 F.3d 338 (3d Cir. 2017). Neither the district court nor the Third Circuit directly reviewed this ruling (because it was not appealed), focusing instead on the goods that were not drop-shipped.

Nevertheless, the bankruptcy court in In re SRC Liquidation, LLC, 573 B.R. 537 (Bankr. D. Del. 2017), relied on World Imports in ruling that goods drop-shipped directly to a debtor's customers were not "received" by the debtor for purposes of section 503(b)(9). In that case, a vendor drop-shipped goods to the debtor's customers using the debtor's United Parcel Service ("UPS") account. The court held that transfer of title to the debtor at the time of shipment did not constitute receipt of goods under section 503(b)(9). Further, the court determined, because UPS is a common carrier, it could not serve as the debtor's agent for the purpose of receipt.

Outlook

World Imports clarifies that "received" under section 503(b)(9) means physical possession of goods rather than the passage of title.

In addition, on the basis of World Imports, SRC Liquidation, and similar rulings, vendors who drop-ship goods directly to customers of a buyer may not rely on section 503(b)(9) to improve their position in the event the buyer files for bankruptcy. To mitigate potential losses, such vendors may be forced to look to their reclamation rights instead. Alternatively, a vendor could require a buyer to take constructive possession prior to delivery of drop-shipped goods by, for example, arranging for receipt of the goods by an agent of the buyer or a bailee when the goods are delivered to a storage facility or processed by a customs agent. See, e.g., Momenta, 455 B.R. at 360–61 (noting that attorning goods to a debtor, e.g., at a storage facility or through receipt by a customs agent, would result in constructive possession for purposes of section 503(b)(9)).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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