N AT I O N A L A S S O C I AT I O N O F C R E D I T M A N A G E M E N T FEBRUARY 2013 THE PUBLICATION FOR CREDIT & FINANCE PROFESSIONALS $7.00 S e l e c t e d t o p i c Bruce NathaN, esq. Drop Shipment Claims Denied Section 503(b)(9) Priority Status B Bankruptcy Code Section 503(b)(9) was enacted in Hear Bruce as he 2005 to provide additional protection for goods suppli- presents, or co-presents: ers. Section 503(b)(9) grants these trade creditors an administrative priority claim for the value of the goods 22048. Bankruptcy Rumblings: they sold in the ordinary course of business to a fjnan- Identifying and Mitigating Risk cially distressed customer that were received within 20 of a Financially Troubled days of its bankruptcy fjling. Customer Headed toward Bankruptcy 22062 & 22072. Bankruptcy Reform Town Although Section 503(b)(9) ofgers goods suppliers a Hall from the Perspective of the Credit step up in priority and enhanced prospects for payment Executive and Other Constituencies of their claims, the courts have had to grapple with many questions about the meaning of this relatively Learn more about this and other legal educational sessions on pp. 28-43. One issue that has proven to be particularly nettlesome is whether goods Tiis issue is particularly important to trade creditors that a creditor, upon the debtor’s who drop ship goods to their buyer’s customers. Unfor- tunately, the United States District Court in New Hamp- instruction, delivers to a third party in a shire in Ningbo Chenglu Paper Products Manufacturing “drop shipment” transaction are deemed Co. Ltd. v. Momenta, Inc., denied Section 503(b)(9) pri- ority status to a trade creditor that drop shipped goods “received” by a debtor in determining to certain of the debtor’s customers within 20 days of whether the creditor has satisfied section the debtor’s bankruptcy fjling. Tie district court based its holding on the debtor’s lack of receipt of the drop 503(b)(9)’s requirements for obtaining shipped goods, which is one of the requirements for priority status. Section 503(b)(9) priority status. section 503(b)(9) “20-Day Goods” Priority claim short and ostensibly simple statute. One issue that has proven to be particularly nettlesome is whether goods Section 503(b)(9) grants goods sellers an administrative that a creditor, upon the debtor’s instruction, delivers to priority claim for: a third party in a “drop shipment” transaction are deemed “received” by a debtor in determining whether “...the value of any goods received by the debtor the creditor has satisfjed Section 503(b)(9)’s require- within 20 days before the date of commencement of ments for obtaining priority status. a case under this title in which the goods have been 1 B u s i n e s s C r e d i t f e B r u a r y 2 0 1 3
sold to the debtor in the ordinary course of such debtor’s sion of a third party, such as a carrier. However, the court did business.” not consider Momenta to be in constructive possession of goods that Ningbo, at the direction of Momenta, had deliv- Debtors and trade creditors have been frequently litigating ered to Momenta’s customers in drop shipment transactions. Section 503(b)(9)’s seemingly straightforward requirements. Tie stakes are huge here as debtors and their secured lenders As such, the bankruptcy court denied Ningbo any priority have been litigating issues, such as what constitutes receipt of status under Section 503(b)(9) for the drop shipped goods. goods, in order to limit trade creditors’ recoveries in bank- Tie court concluded that Momenta had not received the ruptcy cases. goods that Ningbo had drop shipped directly to Momenta’s customers, and, therefore, Ningbo did not satisfy Section Factual Background 503(b)(9). Ningbo appealed the bankruptcy court’s denial of Momenta fjled for Chapter 11 on October 23, 2010 (the “peti- Section 503(b)(9) priority status for its claim for payment of tion date”). Prior to the petition date, Momenta, Inc. ordered the drop shipped goods. Ningbo faulted the bankruptcy court goods from Ningbo Chenglu Paper Products Manufacturing for holding that the same defjnition of “received” is applicable Co. Ltd. During the 20-day period preceding the petition to both reclamation and Section 503(b)(9) priority rights. date, at Momenta’s direction (a) Ningbo delivered three ship- Ningbo argued for a broad interpretation of the term ments valued at approximately $23,000 to Momenta and (b) “received” in Section 503(b)(9) to include a creditor’s drop delivered four other shipments (the “drop shipped goods”) shipment of goods to the debtor’s customers during the 20-day valued at in excess of $140,000, to Momenta’s customers in the period prior to the bankruptcy fjling date. Ningbo relied on United Kingdom and Canada. the preface to UCC Section 2-103(1) which states that its def- inition of “receipt,” taking physical possession of goods, does On December 6, 2010, Ningbo fjled a motion for relief under not apply if “the context otherwise requires.” According to Bankruptcy Code Section 503(b)(9) for the allowance and Ningbo, in the typical drop shipment transaction, “received” payment of an administrative priority claim in the amount of should be defjned “in context” in a way that accounts for the $163,527.95. Ningbo’s motion included a request for payment commercial reality of the arrangement. Buyers and sellers fre- of approximately $140,000 for the drop shipped goods. quently arrange for the sellers’ drop shipment of goods to the buyer’s customers and these arrangements ofuen call for fmexi- Momenta conceded that all seven shipments were for goods bility. A buyer should not be permitted to invoke its decision that Ningbo had sold to Momenta in the ordinary course of to direct the seller’s delivery of goods to the buyer’s customer business. Momenta also conceded that Ningbo was entitled to as the basis for opposing Section 503(b)(9) priority status for Section 503(b)(9) priority status for Ningbo’s three shipments such goods because the buyer had not received the goods. of goods directly to Momenta. Ningbo also claimed that neither Section 503(b)(9) nor Sec- Momenta objected to Ningbo’s motion for Section 503(b)(9) tion 546(c)’s reclamation provision requires a seller to qualify priority status for the value of the drop shipped goods. for reclamation of its goods as a condition for invoking Momenta argued that Section 503(b)(9) did not apply administrative expense status under Section 503(b)(9). Sec- because Momenta had not received the drop shipped goods tion 546(c) states that a seller who has not timely sent a writ- that were shipped directly to Momenta’s customers, which is ten reclamation demand is still eligible for priority status one of the prerequisites for obtaining relief under Section under Section 503(b)(9). Neither Section 546(c) nor Section 503(b)(9). Ningbo disputed this, arguing that a buyer’s 503(b)(9) requires a creditor to satisfy the requirements for “receipt” of goods is not limited to goods that the buyer phys- reclamation (such as the debtor’s continued possession of the ically possesses and includes the drop shipped goods received delivered goods) as a condition for obtaining Section 503(b) by the buyer’s customers. (9) priority status. Tie bankruptcy court refused to grant Ningbo an administra- Momenta asserted a narrow interpretation of Section 503(b) tive priority claim under Section 503(b)(9) for the balance (9). Momenta argued that Section 503(b)(9) is merely a sup- due on the drop shipped goods. Tie bankruptcy court noted plemental remedy that is available only to reclamation credi- that the Bankruptcy Code does not defjne the term “received.” tors who, but for their failure to send a written reclamation Tie court narrowly defjned the term “received” to have the notice required by Section 546(c), would be entitled to recla- same meaning in Section 503(b)(9) as in Section 546(c) that mation of their goods. deals with reclamation rights. 1 Tie court also relied on the meaning of the term “receipt” in determining whether and the District court’s Decision when a debtor “received” goods. While the Bankruptcy Code Tie district court agreed with Momenta’s narrow interpreta- does not defjne “receipt,” the Uniform Commercial Code tion of Section 503(b)(9) and denied administrative priority (“UCC”) defjnes receipt of goods in UCC Section 2-103(c)(1) status for Ningbo’s drop shipped goods. Tie court found that as taking physical possession of the goods. Tiat includes the Momenta had not received the drop shipped goods and, buyer either having obtained actual physical possession of the therefore, was not eligible for a Section 503(b)(9) priority goods or constructive possession of the goods in the posses- claim for the drop shipped goods. Congress intended the 2 B u s i n e s s C r e d i t f e B r u a r y 2 0 1 3
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