Third Circuit Sheds Light on Eligibility for Administrative Priority Under Section 503(b)(9)

In effect, the Third Circuit’s decision provides additional protection to trade vendors that conduct business with distressed debtors. 

Background

Haining Wansheng Sofa Company and Fujian Zhangzhou Foreign Trade Company (collectively, the “Creditors”) supplied goods to World Imports (the “Debtor”). The Creditors shipped the goods more than 20 days before the Debtor’s July 3, 2013 bankruptcy filing (the “Petition Date”), and the Debtor “took physical possession of the goods . . . fewer than 20 days before the bankruptcy filing.” The goods were sent “free on board” (FOB), reflecting an agreement that title, liability, and the risk of loss pass to the Debtor upon “delivery” to the common carrier. To prioritize their claims on account of the goods shipped, the Creditors filed motions seeking administrative priority under section 503(b)(9). Section 503(b)(9) provides administrative priority for certain goods “received” by the Debtor within twenty days before the Petition Date. 

Issue

The Third Circuit framed the issue as whether “receipt” for purposes of section 503(b)(9) occurs on (1) the date of “delivery” to a common carrier; or (2) the date of “physical acceptance.” If the former, the Creditors’ claims would fall outside of the twenty-day window and, therefore, be relegated as general unsecured claims.   

Analysis

Based on the meaning of the term “received,” the Bankruptcy Code’s legislative context, and authority dictating that Congress intended to use the definitions under the Uniform Commercial Code (the “UCC”), the Third Circuit held that goods are “received” upon “physical possession” by the Debtor, not upon the Creditors’ “delivery” to a common carrier. 

Starting with the text and context of section 503(b)(9), the Third Circuit acknowledged that the Bankruptcy Code does not define the term “received” and, therefore, analyzed its ordinary meaning. The Third Circuit examined the definitions of “receive” under Black’s Law Dictionary and the Oxford English Dictionary. Although the definitions are not identical, the Third Circuit nevertheless concluded that the definitions encompass only those goods taken into the Debtor’s “possession, custody, or hands.” These definitions, the Third Circuit explained, are consistent with the definition under the UCC. Because Article 2 of the UCC governed sales of goods in 49 states at the time of section 503(b)(9)’s enactment, the Third Circuit inferred that Congress intended to likewise adopt the UCC’s definition for purposes of section 503(b)(9).

The Third Circuit proceeded to examine section 503(b)(9)’s legislative history and interrelationship with its counterpart, section 546(c). Noteworthy to the Third Circuit was section 503(b)(9)’s purpose as an “exemption” from, or alternative to, section 546(c).^[1] Citing its precedent that section 546(c)’s definition of the term “receipt” is borrowed from the UCC, the Third Circuit interpreted the two statutes together and held that section 503(b)(9)’s definition is likewise borrowed from the UCC. 

The Third Circuit rejected the Debtor’s argument that the goods were “constructively received” upon “delivery” to the common carrier, even if title and risk of loss passed at that time. According to the Third Circuit, “delivery,” or transfer of title or risk of loss, is distinct from actual “receipt,” and each can occur at a different time. After all, the Third Circuit explained, the Creditors have the right to stop delivery of the goods so long as the common carrier remains in possession. In support, the Third Circuit cited precedent dictating that common carriers are not agents of a buyer. “Receipt,” the Third Circuit explained, occurs only when the Creditors no longer have the ability to stop the shipment – namely, upon “physical possession” by the Debtor or its agents. Accordingly, the Third Circuit held that the Creditors’ claims are entitled to administrative priority.

Takeaways

The Third Circuit’s decision establishes that “receipt” of goods occurs when a debtor takes actual “physical possession.” The decision is sound for several reasons – not the least of which is that it is consistent with the common understanding of what “receipt” means. It is also consistent with the Third Circuit’s interpretation of the term “receipt” in the context of reclamation claims under section 546(c). 

Harmonizing and clarifying the meaning of “receipt” in this context establishes a clear rule for vendors shipping goods to businesses in distress. Vendors can expect businesses that “receive” goods within 20 days of filing for bankruptcy in Delaware, New Jersey, Pennsylvania, or the Virgin Islands will be required to afford administrative priority for the value of the goods “received,” as long as all other requirements of section 503(b)(9) are met.^[2]

As part of their due diligence, vendors should review existing agreements with distressed businesses to ensure that goods are delivered directly to the business, and not to a third party.   Where vendors are dealing with an agent of the business, ensure that the agent is one authorized to receive goods on behalf of the business. Where vendors are working with distressed businesses on consignment, note that the business’s physical receipt of the goods, albeit as a bailee, is the operative date for section 503(b)(9). In a pre-World Imports decision, In re Circuit City Stores, Inc., 432 B.R. 225, 229 (Bankr. E.D. Va. 2010), a Virginia bankruptcy court held that suppliers who delivered consigned goods to the debtor, despite retaining title to the goods, did not qualify as administrative claimants because debtor’s initial possession of the goods was outside of the 20 day “look-back” period of section 503(b)(9).
 
In the same vein, for vendors in “drop shipment” arrangements, where goods are not shipped directly to a distressed company but to the company’s customers or sub-purchasers, resulting claims would not constitute administrative claims under section 503(b)(9) because the company would not receive physical possession of the goods. Such vendors should exercise discretion in dealing with distressed businesses or should negotiate for purchase money security interest to protect against negative treatment in bankruptcy. 

This was an encouraged practice even before the Third Circuit’s ruling. Its predecessor, In re World Imports, 516 B.R. 296, 298-300 (Bankr. E.D. Pa. 2014), noted that drop-shipment to a debtor’s customers does not constitute even constructive possession. With the Third Circuit’s clarification of “receipt,” this practice is now imperative for “drop shipment” vendors. In SRC Liquidation LLC, 573 B.R. 537, 542 (Bankr. D. Del. July 13, 2017) – the only decision applying the Third Circuit’s ruling thus far – the Delaware bankruptcy court found that drop-shipped goods were not received for purposes of § 503(b)(9) because the debtor’s customer rather than the debtor received delivery of the goods, despite at the debtor’s direction and with the debtor’s shipping account.

This decision, though important for purposes of determining when a section 503(b)(9) expense accrues, does not guarantee that the administrative claim will in fact be paid. To assure payment, vendors must exercise diligence and pursue their section 503(b)(9) rights during a bankruptcy case, including filing a timely proof of claim under section 502 and keeping a record of documents to support the claim (i.e., proof of actual receipt by the debtor, itemized documentation of the value of the goods and any associated costs and fees, etc.).