Business Bankruptcy Issues

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Business Bankruptcy Issues Recent Developments

Copyrights And Bankruptcy Sales: The Importance Of Protecting Your Rights

I’ve posted in the past about bankruptcy asset sales and how parties with executory contracts need to keep track of bankruptcy cases to protect their rights. Steve Jakubowski of The Bankruptcy Litigation Blog has an entertaining and informative post about a recent Court of Appeals decision involving rappers, recording companies, copyrights, and bankruptcy that raises some similar issues.

It’s a cautionary tale about the importance of monitoring bankruptcy cases and acting to protect rights when copyrights are involved. (So you don’t get complacent, the same message applies for patents, trademarks, and other intellectual property, and especially when licenses are involved.) After describing the case briefly, I discuss some points to keep in mind when IP crosses the bankruptcy court’s door.

Setting The Stage. Some background on the facts of the case will help put things in perspective.

  • Act One: In 1989, Jeffrey Thompkins, a rap artist known as JT Money, entered into an exclusive recording agreement with the debtor (a recording company). In the agreement, Thompkins sold his sound recording copyrights in various songs in exchange for the debtor’s agreement to pay royalties on the records released. (A later agreement made the debtor a half owner in the musical composition copyrights as well.)
  • Act Two: Six years later, the debtor ended up in Chapter 11 bankruptcy. The copyrights were sold "free and clear" to another recording company for $800,000 as part of the debtor’s plan of reorganization, which the bankruptcy court confirmed. The recording agreement was ultimately rejected as an executory contract. Apparently, Tompkins neither objected to the sale nor defended his claim for damages after the recording agreement was rejected.

The Curtain Falls. Almost six years after the bankruptcy sale, Tompkins sued the purchaser of the copyrights in federal court, alleging copyright infringement and other claims. The district court granted the purchaser’s motion for summary judgment and the decision was affirmed on appeal. The Court of Appeals for the Eleventh Circuit held that even though the debtor had rejected the original recording agreement, under bankruptcy law that rejection acted only as a breach and not as a rescission of the contract. Quoting from earlier decisions, the Court of Appeals commented that rejection does not "vaporize" a debtor’s rights under a rejected contract. Here the debtor retained ownership of the copyrights transferred under the recording agreement even though it breached the obligation to pay royalties. Because the purchaser was the actual owner of the copyrights, the infringement claim failed.

Encore: Lessons For The Audience. What can intellectual property owners and debtors learn from this decision?

  • A transfer of IP under an executory contract will not be rescinded if the buyer later files bankruptcy and rejects the agreement.
  • An IP owner looking for more control over its IP should consider granting a license instead of making an outright sale subject only to a royalty obligation. In some industries this may not be a realistic alternative, but when possible it can give IP owners more control. 
  • In many jurisdictions, IP owners who have granted only non-exclusive licenses prohibiting assignment will have the equivalent of a veto right in bankruptcy over proposed assignments of the license. This is generally true for copyrights, patents, and possibly trademarks, and can have a big impact on a debtor’s ability to transfer license rights.
  • When a licensee or other debtor with rights related to IP files bankruptcy, it’s critical for IP owners to monitor the bankruptcy case and be prepared to take action to defend their rights. Among the issues that can come up: asset sales involving a sale of the IP or an assignment of license rights, breaches of license terms, and infringement issues.
  • Likewise, debtors and creditors committees need to understand what IP rights the debtor has, what consents may be required to assign or transfer those rights, and how the rights of third party licensors and other IP owners may impact asset sales and reorganization prospects.

Conclusion. The intersection between intellectual property and bankruptcy law can be complex. Whether you are an IP owner, a debtor, or a committee, getting good legal advice before and after a bankruptcy is filed can be critical in protecting your rights.

Business Bankruptcy Issues Recent Developments

Delaware Bankruptcy Court Denies Reclamation Claimant’s TRO Request To Stop Sale Of Goods

In a recent post, I discussed how Section 546(c) of the Bankruptcy Code, as revised by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA"), gives vendors the ability to assert a reclamation claim for goods received by a debtor in the 45 days prior to the bankruptcy filing. In addition to extending the reclamation period to 45 days, BAPCPA also added a provision in Section 546(c) making reclamation claims "subject to the prior rights of a holder of a security interest in such goods or the proceeds thereof." This quoted language refers to a secured creditor with a senior lien in the same goods.

The Advanced Marketing Services case. Section 546(c)’s expanded reclamation rights, and how they may be impacted by the "prior rights" of a secured creditor, recently played out in the Chapter 11 bankruptcy case of In re Advanced Marketing Services, Inc. pending in the United States Bankruptcy Court in Delaware.

Simon & Schuster, Inc., a reclamation claimant, filed a complaint against the debtor, Advanced Marketing Services, Inc. ("AMS"), seeking to reclaim more than $5 million worth of goods that the debtor allegedly received in the 45 days prior to the bankruptcy filing. (You can access the pleadings from the Simon & Schuster litigation by clicking on the appropriate links in this post.)

  • In an effort to gain control over the goods at issue, Simon & Schuster filed an application for a temporary restraining order (known as a "TRO") seeking a court order to prevent AMS from selling the goods. 
  • The debtor opposed the TRO, challenging whether Simon & Schuster had the right to reclaim the goods.
  • The debtor’s secured creditor, Wells Fargo Foothill, Inc., also filed an opposition to the TRO, arguing that the reclamation claim was subject to its prior rights as a prepetition secured creditor and as a debtor in possession ("DIP") lender. In this case, the DIP loan has been structured as a "creeping roll up" in which prepetition obligations are to be satisfied by the use of cash collateral and the DIP lender in turn receives a postpetition lien as that cash collateral is used.
  • Simon & Schuster filed a reply brief responding to the opposition papers filed by the debtor and the secured creditor.

The Court’s Decision. In a decision issued by the Bankruptcy Court yesterday, Judge Sontchi denied Simon & Schuster’s application for a TRO without prejudice, holding that Section 546(c) made Simon & Schuster’s reclamation rights subject to the prior rights of the secured creditors. (The Bankruptcy Court also noted that it would have reached the same result under pre-BAPCPA bankruptcy and UCC law.)

  • The Bankruptcy Court held that the secured creditors had superior prepetition and postpetition liens in the goods Simon & Schuster sought to reclaim and that Simon & Schuster therefore could not establish that it was likely to prevail on the merits of its reclamation claim.
  • The Bankruptcy Court also rejected any attempt to require "marshaling" by the secured creditor, which if ordered could have required the secured creditor to satisfy its claim first from collateral other than the goods that Simon & Schuster sought to reclaim.

Stay Tuned. As one of the first decisions on this reclamation issue under BAPCPA, the Advanced Marketing Services decision is an important one. However, it’s not the last word on how the respective rights of reclaiming vendors and secured creditors will be decided in Chapter 11 cases. Reclamation issues are often fact dependent and results may vary in different cases. Also, vendors unable to prevail on a reclamation claim may still have a "20 day goods" administrative claim, and this fact may influence how debtors treat vendors in future cases.  

Business Bankruptcy Issues Recent Developments

Second Liens and Intercreditor Agreements: Are Those Bankruptcy Voting Provisions Really Enforceable?

In this post I look at the second lien phenomenon and then discuss an interesting new case addressing whether a fairly common intercreditor agreement provision — giving a senior lender the right to vote a second lien lender’s claim in bankruptcy — will actually be enforced.

Senior Debt And Mezzanine Financing. When a company borrows from a bank, it typically grants the bank a first priority, blanket security interest in all of its assets to secure this senior debt. In the past, when a company needed additional capital, whether to grow the business or to fund an acquisition, it often turned to unsecured "mezzanine" financing, so named to reflect its middle position between senior debt and equity. This type of unsecured debt typically is subject to complete payment subordination in favor of the senior lender and is considerably more expensive than bank debt. 

The Second Lien Market. One of the biggest financing trends in recent years has been the move away from unsecured mezzanine credit to debt secured by a second priority security interest on all of the company’s assets. Much of this "second lien" debt is coming from hedge funds and other private equity funds, although more traditional lenders have also become active in the market. According to CFO.com, the second lien market has grown dramatically over the past several years, from $570 million in 2002 to more than $16 billion in 2005. Some reports suggest it approached $30 billion in 2006. 

Why the attraction to second lien financing? The main reasons are price, terms, and availability. Healthy companies generally find the pricing on second lien credit to be lower than unsecured mezzanine debt (although a bit more expensive than on senior debt) and often comes with few covenants. For distressed companies, if they can obtain additional credit at all, many times it’s as part of a restructuring in which a new lender requires a second lien to protect it from an increased risk of default. 

Subordination and Intercreditor Agreements. Most second liens are blanket security interests and cover the same collateral against which the senior lender has a first lien. Traditionally, senior lenders include provisions in their loan documents prohibiting borrowers from granting security interests or liens to any other lender without the consent of the senior lender. When a lender proposes to make a second lien (also known as a "junior" or "tranche B" loan), it must negotiate not only with the borrower but also with the senior or "tranche A" lender. As the size of the second lien market suggests, senior lenders have been willing to consent to second lien loans, often to help the borrower make an acquisition or to bring in additional liquidity.

  • The negotiations between the first and second lien lenders usually address their respective rights to the collateral and various provisions regarding repayment of their loans. Sometimes the second lien debt will be subordinated to repayment of the senior debt, as with traditional mezzanine financing, but more often only the security interest in the common collateral will be subordinated to that of the senior lender.
  • The senior lender generally insists that the junior lender be a "silent second" and waive rights to object to actions taken by the senior lender in a default or bankruptcy. The junior lender instead wants to have the ability to protect its own interests. The end result often comes out somewhere in between, but restrictions on the second lien lender are common.
  • The arrangements between the senior and second lien lenders are documented in a separate agreement, usually called an intercreditor agreement or a subordination agreement.

Key Intercreditor Agreement Provisions. If everything goes well and the borrower repays its loans on time, the provisions of the intercreditor agreement won’t be all that important. However, if the borrower defaults on the loans, or files for bankruptcy, the terms of the agreement can become critical.

  • With bankruptcy in mind, key provisions negotiated in intercreditor agreements often include waivers or consents by the second lien lender relating to debtor in possession (DIP) financing, use of cash collateral, rights to adequate protection, conduct of a Section 363 sale of the debtor’s assets (i.e., the lenders’ collateral), and the extent to which the senior lender will have the right to vote the second lien lender’s claim on any Chapter 11 bankruptcy plan of reorganization.
  • Section 510(a) of the Bankruptcy Code provides that a "subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable nonbankruptcy law." Bankruptcy courts routinely enforce payment subordination provisions in which the junior lender agrees not to receive any payments (or to turn over any that it does receive) until the senior lender is paid in full.

Bankruptcy Voting Provisions. Bankruptcy voting provisions, however, have not always been enforced. Most notably, the court in In re 203 North LaSalle Street Partnership, 246 B.R. 325 (Bankr. N.D. Ill. 2000), held that Section 1126(a) of the Bankruptcy Code, which provides that the "holder of a claim or interest allowed under section 502 of this title may accept or reject a plan," means that only the actual holder of the claim may vote and that an agreement giving that right to the senior lender is not enforceable. Other courts have been more willing to enforce voting provisions in subordination agreements. Still, the issue has not come up very often. Voting provisions have been the subject of reported decisions in only a handful of cases over the past 25 years.

The Aerosol Packaging Decision.  That dearth of authority makes the decision in In re Aerosol Packaging, LLC, issued by a bankruptcy court in Atlanta in late December 2006, of keen interest. (Thanks go to Scott Riddle of the Georgia Bankruptcy Law Blog for first posting on the decision.) In that case, Wachovia Bank was the senior lender under a subordination agreement entered into with Blue Ridge Investors, II, L.P., a second lien lender to the debtor, Aerosol Packaging. In its Chapter 11 bankruptcy, the debtor filed a plan of reorganization acceptable to Wachovia. When votes were solicited, both Wachovia and Blue Ridge submitted competing ballots voting Blue Ridge’s claim, with Wachovia’s ballot accepting the plan’s primary treatment of Blue Ridge’s claim and Blue Ridge’s ballot rejecting that proposed treatment.

  • Blue Ridge then filed a motion seeking a determination of its voting rights and allowance of its ballot instead of the one Wachovia submitted. (For reference, the subordination agreement attached as an exhibit to that motion designates Blue Ridge as the "Subordinated Creditor" and Wachovia, as successor to SouthTrust Bank, as the "Lender.")
  • Wachovia opposed the motion, relying on a section in the subordination agreement that made it, as the Lender, "irrevocably authorized and empowered (in its own name or in the name of the Subordinated Creditor)" to "take such other action (including without limitation voting the Subordinated Debt. . . " as it "deemed necessary or advisable." Wachovia also argued that the In re 203 North LaSalle Street Partnership case, relied on by Blue Ridge, was wrongly decided and that the bankruptcy rules allowed agents to vote another party’s claim. 
  • To complete the picture, the debtor itself also filed a response supporting Wachovia’s position.

In siding with Wachovia, the bankruptcy court held that Wachovia was the agent of Blue Ridge, that under the subordination agreement Blue Ridge assigned its right to vote to Wachovia, and that Section 1126(a) of the Bankruptcy Code does not prohibit the enforcement of such provisions. The court therefore accepted Wachovia’s ballot and rejected the one submitted by Blue Ridge. The court also pointed out that Blue Ridge is not without a remedy: it "may free itself from the ongoing effect of the Subordination Agreement by paying the Wachovia claim in full in cash." Blue Ridge has appealed the decision, so a higher court may have a chance to rule on the issue.

Uncertainty Remains. As only one bankruptcy court ruling, the Aerosol Packaging decision does not settle the issue of whether bankruptcy voting provisions will be enforced. Still, it’s interesting that the court considered and rejected the reasoning of the In re 203 North LaSalle Street Partnership decision. Given that this subordination agreement involved both lien and payment subordination, it’s unclear whether the voting provision would have been enforced if the lenders’ agreement had involved only lien and not payment subordination, which is the more typical second lien arrangement. The answer to that question will have to wait for the next case.

Business Bankruptcy Issues Recent Developments

Bankruptcy Notices: New Rule Lets Creditors Choose A Preferred Address

You’re a creditor in a bankruptcy case and a bankruptcy notice arrives on your desk setting a deadline to object to an important motion. The address on the notice is a P.O. box located a thousand miles away, one used only for customer payments and not for legal notices. As a result, the notice took a long time to be routed to you. When you look at it more closely, you realize that so much time has passed that the deadline to respond was last week and the hearing took place yesterday. The situation can be even worse if the late-arriving notice is about a deadline (also known as a "bar date") for filing a proof of claim or perhaps for responding to an objection to your claim. 

Sound familiar?

Ability To Designate An Address. Well, one of the lesser known changes made by the 2005 amendments to the Bankruptcy Code, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA"), permits creditors to designate a preferred address for receiving bankruptcy notices. Section 342(f) of the Bankruptcy Code, added by BAPCPA, allows creditors to use one preferred address for cases in every bankruptcy court in the country or to designate different addresses for cases in specific bankruptcy courts.

National Creditor Registration Service. To implement this new rule, a National Creditor Registration Service ("NCRS") has been created. According to its website, the NCRS is "a free service provided by the U.S. Bankruptcy Courts to give creditors options to specify a preferred U.S. mail, e-mail address, or fax number to which bankruptcy notices should be sent." Creditors can choose to receive paper notices mailed to one or more designated addresses or faxed to specific fax numbers. Creditors also have the option of receiving bankruptcy court notices via email by registering for the Electronic Bankruptcy Noticing ("EBN") system.

  • A creditor’s preferred address and delivery method will be substituted for any address used in a bankruptcy mailing matrix (the official list of addresses for its creditors that a debtor files with the bankruptcy court) within 30 days of the creditor’s registration. (Although Section 342(f) itself mentions only Chapters 7 and 13 of the Bankruptcy Code, as implemented the system is being applied to all cases, including Chapter 11 cases.)
  • When registering, it’s important to list all of the different versions of a creditor’s name, including formal corporate names, a "doing business as" name, and even common misspellings of the creditor’s name. The service’s software will attempt to match the names the creditor supplied to the one listed in the debtor’s mailing matrix. If a match cannot be made, the notice will be sent to the address listed by the debtor.
  • NCRS allows you to complete forms online or to print them and send them in. You can find the registration forms here, here, and here, but I suggest going to the NCRS registration website itself to make sure you are using the most up-to-date forms and procedure.
  • A creditor or its bankruptcy counsel can always file a request for special notice with the bankruptcy court in a particular case using a specific address for notices in that case. In that circumstance, the address listed in the case-specific notice request will be used instead of the NCRS-listed address.

Be Prepared. Regardless of which option creditors choose, they should be prepared to handle the volume of notices that may be directed to the physical or email address. If using a physical address, creditors should be sure to monitor that address regularly and be in a position to process the notices received. A dedicated P.O. box may make sense in some cases. If an email address is used, it may be helpful to use a special email address or account for notices, create email rules to direct notices to the right person, or use other software to monitor and process those notices. With good procedures in place, the NCRS and EBN services should help creditors receive important bankruptcy notices in time to protect their rights.

What If Something Goes Wrong? Another new provision, Section 342(g), governs the situation in which notice does not get to the right address. Although courts have not yet answered how it applies in various contexts, the section provides that a notice is not "effective notice" unless it’s sent in compliance with the Bankruptcy Code’s notice rules or it’s actually brought to the creditor’s attention.

  • This section allows a creditor to designate "a person or an organizational subdivision" to be responsible for receiving bankruptcy notices. If the creditor also establishes "reasonable procedures" so that notices are delivered to the designated person or subdivision, a notice sent to the creditor other than in accordance with Section 342’s procedures "shall not be considered to have been brought to the attention of such creditor until such notice is received by such person or such subdivision."
  • In addition, a creditor that did not receive a notice of the bankruptcy filing complying with Section 342’s provisions may have a defense to a claim that it violated the automatic stay.
  • While helpful to creditors, these provisions raise questions about how debtors and trustees can be sure to send out effective notice, especially if they are not aware of which person or subdivision a particular creditor has designated for notice. That problem will be reduced if many creditors register with the NCRS or EBN system.

Get Advice. As always, if you have questions about these procedures or how they may affect you as a debtor or creditor, be sure to get advice from your bankruptcy counsel.

Business Bankruptcy Issues The Financially Troubled Company

20 Day Goods: New Administrative Claim For Goods Sold Just Before Bankruptcy

In a recent post about a vendor’s reclamation rights, I discussed how the 2005 amendments to the bankruptcy laws, known as the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (called "BAPCPA"), extended a vendor’s right to reclaim goods once a bankruptcy petition has been filed. This post focuses on another of BAPCPA’s important changes affecting vendors, specifically, the new provision giving vendors an administrative claim for certain pre-petition goods sold.

Expanded Reclamation Right. As mentioned in my earlier post, a new 45 day bankruptcy reclamation right was added to Section 546(c) of the Bankruptcy Code. Prior to this change, the Bankruptcy Code had merely incorporated the Uniform Commercial Code’s 10-day reclamation period. Now, once a bankruptcy is filed, a vendor can assert a reclamation demand for goods received within 45 days of the bankruptcy filing. However, in some cases a vendor may not be able to reclaim its goods. The reasons can include a failure to make a timely reclamation demand, the existence of a secured lender with a lien on the goods in question, or the debtor’s prior sale of the goods. 

A Brand New Administrative Claim For Vendors, Even If Reclamation Fails. If a vendor’s reclamation claim fails, another new Bankruptcy Code section, Section 503(b)(9), gives vendors an important additional right: an administrative priority claim for "the value of any goods received by the debtor within 20 days before" the date a bankruptcy petition was filed "in which the goods have been sold to the debtor in the ordinary course of such debtor’s business." 

In most cases, administrative claims are paid in full instead of only cents on the dollar as with general unsecured claims. This new administrative claim is therefore a significant benefit, in effect putting vendors selling goods to a debtor in the 20 days before the bankruptcy filing on par with vendors selling goods after the bankruptcy filing.

  • Section 546(c)(2) of the Bankruptcy Code expressly provides that even if a seller of goods fails to provide the required notice to have a post-bankruptcy reclamation claim, the vendor may still assert this special Section 503(b)(9) administrative claim. 
  • This administrative claim applies in all types of bankruptcy cases, including Chapter 11 reorganization cases, Chapter 7 liquidation cases, and Chapter 13 cases.
  • Vendors who sold goods during the 21 to 45 day period before the bankruptcy filing will have to rely on reclamation alone as to those goods.
  • In either case, vendors and debtors should keep good records of shipments and deliveries of all goods received during the 45 days before the bankruptcy filing.

Unresolved Issues. This provision has been in effect for only a year and there are still a number of unanswered questions about how it will actually work in bankruptcy cases. Reviewing these questions may give you a sense of some of the issues to keep in mind when considering whether you (if you’re a vendor) or your vendors (if you’re a debtor) will have an administrative claim for "20 day goods." These issues include:

  • Since the vendor is entitled to an administrative claim for the "value of any goods received by the debtor," does that mean the invoice price or some other amount?
  • Does the term "goods" include services bundled with the goods?
  • Does the term "goods" include intellectual property-based products, such as boxed software or other similar items, which the debtor resells or sublicenses?
  • Does the "received by the debtor" requirement exclude goods that have been drop-shipped to a debtor’s customer at the debtor’s direction?
  • What does the requirement that the goods have been "sold to the debtor in the ordinary course of such debtor’s business" really mean?
  • Does the vendor have to file a pleading to be paid on this administrative claim, given that this new section requires "notice and a hearing"?
  • Can the debtor pay for the goods at the beginning of the case, much as it would for goods purchased after the bankruptcy filing, as a way of treating qualifying vendors as "critical vendors"?
  • Can the debtor wait to pay for these "20 day goods" until a plan of reorganization goes effective, as it can for certain other administrative claims?
  • If a Chapter 11 case converts to a Chapter 7 case, will this "20 day goods" administrative claim be treated as a Chapter 7 administrative claim, ahead of all unpaid Chapter 11 administrative claims, including those for goods sold during the Chapter 11 case?
  • Will the existence of this administrative claim provision give vendors who actually got paid before the bankruptcy for "20 day goods" a new defense to a claim that the payment was preferential? 

Get Good Advice. These issues, and the potential for a valuable administrative claim, are yet another reason for vendors to get good legal advice as soon as they learn of a bankruptcy filing. Debtors also need to get good advice, both legal and financial, so they can factor in how the requirement to pay for these pre-petition goods as an administrative claim will impact their cash needs.

Stay Tuned. This provision has been in effect for only one year, and applies only to cases filed after BAPCPA took effect on October 17, 2005. No formal court decisions have addressed, much less answered, these open questions. I expect bankruptcy courts will start to answer some of these questions in the coming months, and I’ll keep you updated on those developments. 

Business Bankruptcy Issues The Financially Troubled Company

Reclamation: Can A Vendor “Get The Goods” From An Insolvent Customer?

Although vendors sell goods to get paid, it doesn’t always work out that way. If the customer is insolvent or files bankruptcy, the vendor may be stuck with an unpaid account. To make matters worse, some customers (especially those with limited prospects for financing) may even "load up" on inventory and then file bankruptcy without paying. Regardless of why it happens, no one wants to ship goods and not get paid.

Some vendors, however, may be able to take advantage of a special, although limited, right to get back or "reclaim" certain of the goods. This reclamation right is part of both the Uniform Commercial Code and the Bankruptcy Code. The recent 2005 amendments to the bankruptcy laws, known as the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (called "BAPCPA"), made some significant changes that have enhanced a vendor’s rights in a bankruptcy. This post discusses how reclamation rights play out both before and after bankruptcy.

Reclamation before bankruptcy. If the customer has not filed for bankruptcy, a vendor’s reclamation rights are governed by the Uniform Commercial Code (known as the "UCC"). UCC Section 2-702 is the UCC"s reclamation statute. It provides a seller with the right to reclaim goods that a customer received on credit "while insolvent" if the seller makes a demand within ten days after the customer received the goods. This 10-day period means that, absent a bankruptcy, a vendor’s reclamation right will be limited to reclaiming only those goods received by the customer in the ten days prior to the demand.

  • Under the UCC, "insolvent" means (A) having generally ceased to pay debts in the ordinary course of business other than as a result of good faith dispute; (B) being unable to pay debts as they become due; or (C) being insolvent within the meaning of federal bankruptcy law.
  • Under the federal Bankruptcy Code, insolvent means that the entity’s debts exceed the value of its assets at a fair valuation. This is essentially a balance sheet test but, importantly, one using market value and not financial reporting standards such as GAAP. Because they are prepared for a different purpose, GAAP balance sheets tend to overstate asset values and understate actual liabilities compared to the bankruptcy balance sheet test. Companies that might seem solvent under GAAP could be insolvent under the UCC or the Bankruptcy Code.
  • If the customer misrepresented its solvency in writing during the three months before the delivery of the goods in question, then the 10-day limitation does not apply.

The UCC reclamation demand. To exercise a reclamation right before bankruptcy, the vendor must make a demand. The demand should be in writing, directed to the customer, identify which goods are being reclaimed to the extent that information is available, include a general statement reclaiming all goods received by the customer from the vendor during the applicable time period, and demand that the goods be segregated. Vendors should consult with counsel to be sure the demand adequately protects their reclamation rights.

Reclamation after bankruptcy. Because of changes made in the 2005 amendments to the Bankruptcy Code, applicable to all bankruptcy cases filed on or after October 17, 2005, the filing of a bankruptcy now actually expands a vendor’s reclamation rights. These new provisions apply in both Chapter 11 reorganization cases and Chapter 7 liquidation cases. Some of the key changes include:

  • A new, 45-day bankruptcy reclamation right has been added to Section 546(c) of the Bankruptcy Code. Prior to this change, the Bankruptcy Code had merely incorporated the UCC’s 10-day period. Now, once a bankruptcy is filed, a vendor can assert a reclamation demand for goods received within 45 days of the bankruptcy filing.
  • The goods must have been sold in the "ordinary course" of the vendor’s business and the debtor must have received the goods while insolvent (using the Bankruptcy Code’s definition of insolvent discussed above).
  • The reclamation demand must be in writing and made within 45 days of the receipt of the goods by the customer (now the debtor in bankruptcy).
  • If the 45-day period expires after the bankruptcy case is filed, the vendor must make the reclamation demand within 20 days after the bankruptcy filing.
  • As with pre-bankruptcy demands under the UCC, the demand should identify the goods being reclaimed, include a general statement reclaiming all goods received by the debtor from the vendor during the 45-day period, and demand that the goods be segregated. Vendors may also want to file a notice of reclamation with the bankruptcy court.

Sold goods and other issues. Whether before or after a bankruptcy filing, a vendor will lose its right to reclaim any goods that the customer sells before or after receiving the vendor’s reclamation demand. 

  • Absent an agreement with the customer or a reclamation program approved by the bankruptcy court (see this example from the Delphi case, which was filed before the new BAPCPA rules took effect), a vendor may be forced to seek and obtain a court order preventing further sales of goods while its reclamation claim is pending. 
  • This "sold goods" problem has probably become more important because BAPCPA removed language from the prior version of Section 546(c) that had allowed a bankruptcy court to give a reclaiming vendor an administrative claim (with priority over unsecured claims and certain other claims) in lieu of a return of the goods.
  • Both the UCC and the Bankruptcy Code require that the debtor itself must have received the goods for them to be reclaimed. Thus, goods that are drop shipped or otherwise delivered first to the debtor’s own customer likely will not be able to be reclaimed.
  • If the debtor made a misrepresentation of its solvency and then filed bankruptcy, it’s unclear whether the 45-day rule in bankruptcy will govern or whether, like under the UCC, no time limit will apply. Keep in mind, however, that often goods shipped as far back as 45 days or longer, and sometimes even as few as 10 days for debtors with fast inventory turns, may already have been sold and thus will not be subject to reclamation. 

Rights of secured creditors. A vendor’s reclamation right is further limited by the possibility that the debtor may have granted a bank or other creditor a security interest in the goods, which will be senior to the reclamation right.  As amended in 2005, Section 546(c) now expressly makes reclamation rights subject to the prior rights of a secured creditor with a security interest in goods or their proceeds.

New administrative claim for 20-day goods. Even if a vendor fails to make a reclamation demand, all may not be lost. A new Bankruptcy Code section, Section 503(b)(9), added by BAPCPA, gives vendors an administrative priority claim for the value of any goods received by the debtor within 20 days prior to the bankruptcy filing if the goods were sold in the ordinary course of the debtor’s business. (I intend to discuss this new provision in a future post.) For now, note that it may be an important "fall back" right for vendors who fail to make a reclamation demand or who are unable to reclaim goods for other reasons.

Impact of new reclamation right on debtors and other creditors. With every new right also comes new burdens. Vendors certainly have greeted as good news the ability to reclaim goods received by a debtor as far back as 45 days. The impact of these changes on debtors, however, remains unclear. Some bankruptcy attorneys wonder whether this expanded reclamation right, together with the administrative claim for 20-day goods and certain other changes made by BAPCPA, will make it more difficult for debtors to reorganize or otherwise to pay unsecured creditors.

As always, get good legal advice. Reclamation can involve a number of twists and turns. Vendors who think they may have reclamation rights should be sure to get legal advice immediately upon learning of a customer’s insolvency or bankruptcy to protect their interests, just as debtors should to know their own rights in response to reclamation demands.

Business Bankruptcy Issues

Bankruptcy Asset Sales: What Parties With Contracts Should Watch For

In many corporate bankruptcy cases, the debtor will use the bankruptcy process to sell its assets and to assume and assign valuable leases, executory contracts, and licenses (see earlier posts on what happens to leases in bankruptcy, to executory contracts, and to intellectual property licenses, a special type of executory contract). 

This post discusses some mechanics of the bankruptcy sale process and points out how parties to executory contracts and leases can protect their rights. (A discussion of the sale process from the buyer’s perspective can be found here.)

The Section 363 sale.  A bankruptcy asset sale often will happen in the first few weeks or months of a Chapter 11 case, rather than as part of a plan of reorganization. Frequently this will involve a sale of all or substantially all of a debtor’s business as a going concern. You may hear the sale referred to as a "Section 363 sale" because Section 363 is the key Bankruptcy Code section that governs a debtor’s sale of assets in bankruptcy. Regardless of what is being sold, the debtor must seek bankruptcy court approval of the sale and of any effort to transfer executory contracts, licenses, and leases to the buyer. 

Sales "free and clear" of liens. When the debtor files a motion seeking to sell its assets, it usually will ask to do so free and clear of liens. The term "lien" includes everything from UCC security interests filed by banks or other secured lenders taking the debtor’s assets as collateral for loans to judgment and other types of liens. In a Section 363 sale, a debtor may propose to sell the assets and hold the sale proceeds in a separate account, with the secured creditors’ liens being transferred over to those funds. Debtors ask for authority to sell the assets "free and clear" of liens because the buyer wants clear title to the assets, unencumbered with any of the debtor’s old debts and liens.

Motion to assume and assign executory contracts and leases. The debtor will typically file another motion (or may combine it with the motion to sell free and clear) seeking authority to assume and assign to the buyer certain executory contracts and leases.  If you are a party to an executory contract or lease, you should follow the sale process closely because your rights could well be affected. 

  • The debtor will likely send out a notice to parties to executory contracts and to landlords with a list of the contracts and leases proposed to be assumed and assigned. This is a very important document and you or your counsel should review every page carefully. 
  • The notice typically will list the amount the debtor proposes to pay to “cure” any defaults. The debtor must cure any defaults in cash before the contract or lease can be assumed and assigned to the buyer. Very often the notice will indicate that the proposed cure amount for some contracts or leases is zero or it may leave the amount blank with an asterisk stating that the debtor believes that no cure amount is owed. 
  • Here’s an example of a notice, with a fairly typical multi-page chart listing scores of contracts to be assumed and assigned as part of the sale and indicating proposed cure amounts. 

Scream or die. This isn’t a warning in a horror film but a phrase bankruptcy lawyers have coined to describe a creditor’s requirement to file an objection by the stated deadline or face the loss of your rights. (You have to admit it’s catchy.) To put it in less vivid terms, if you want to object (1) to the assignment of your executory contract, license, or lease at all, (2) to its assignment to the particular buyer proposed, or (3) even to the amount proposed to be paid to cure defaults, you have to file a written objection by the deadline listed in the notice. If you don’t, the debtor will ask the bankruptcy court for an order approving the transfer of your contract, license, or lease, and that may well involve no cure payment at all. Because bankruptcy cases move quickly by necessity, "screaming" after the deadline will generally be too late.

Got counsel?  If you have an important executory contract, intellectual property license, or commercial lease with a debtor, having your counsel monitor the bankruptcy case and review any sale motions and assumption and assignment notices is the best way to protect your rights. Otherwise, you may miss an opportunity to receive a cure payment, to object to an assignment of an intellectual property license, or otherwise to exercise your rights in the bankruptcy case.