Can the Marshalling Doctrine Rescue Reclaiming Creditors?

There is a split of authority involving treatment of valid reclamation claims where a floating lien in after-acquired inventory is held by a secured lender.

Some cases simply hold that the vendor is entitled to a lien or an administrative priority claim for the amount of the goods sought to be reclaimed. These cases are based on the plain language of Section 546(c) which states that “the court may deny reclamation to a seller with such a right of reclamation…only if the court grants the claim of such a seller priority as a claim of a kind specified in section 503(b) of this title or secures such claim by a lien.” 11 U.S.C. ' 546(c). Thus, Section 546 (c) entitles a reclaiming creditor to an administrative expense priority or lien in the full amount of its reclamation claim.

Still other courts hold that a reclamation claim is subordinated to the floating inventory lien of the secured lender. However, in cases where the reclamation claim is subordinated the courts generally find that there is insufficient inventory value to fully satisfy the first-priority lien of the secured lender from the sale proceeds of inventory, thereby effectively rendering any reclamation claim valueless. In effect, these courts find that a reclamation claim is extinguishable whenever the inventory proceeds are paid to a secured creditor — even if the secured creditor is ultimately oversecured when all of its collateral is liquidated. See In re Arlco, 239 B.R. 261 (Bankr. S.D.N.Y. 1999, (vendor's reclamation claim was valueless because the proceeds of the debtor's inventory were insufficient to satisfy the secured lender even though secured lender was later found to be fully secured).

Is the protection that UCC Section 2-702 and Bankruptcy Code Section 546(c)(2) provide to reclaiming vendors being undermined and determined arbitrarily by the sequence in which collateral is liquidated?

By way of example, assume that a secured lender has a perfected lien on all of the debtor's assets, including a floating lien on after-acquired inventory and a lien on choses in action. Assume further that at the time a vendor made its reclamation demand, the debtor held an unliquidated claim against various officers and directors of the debtor for alleged misconduct. Further, assume that this litigation claim against former management (chose in action) is eventually settled during the bankruptcy case for several millions of dollars — but long after the debtor's inventory had been liquidated. Finally, assume that if the settlement proceeds were added to the balance sheet of the debtor at the time reclamation demand was made, the debtor would have had sufficient funds to pay all secured liens in full and to pay a dividend to unsecured creditors. It seems under these facts that the secured lender's lien in after-acquired inventory should not extinguish the reclamation claim, but according to some courts, it does.

Is this the right result? Should a reclaiming creditor be denied relief simply because inventory proceeds are usually paid to a secured lender first – even where the secured lender is ultimately found to be over-secured when the liquidation of all of its collateral has been completed? When should the rights of a reclaiming creditor be determined, at the time inventory is liquidated, after all of the secured lender's collateral is liquidated or at some other point in time?

Can it be argued that those cases which hold that a reclaiming creditor's right are either cut off or rendered valueless even where the proceeds of the secured party's collateral is sufficient to satisfy its lien in full are based upon the arbitrary sequence in which collateral is liquidated and create a windfall for unsecured creditors at the expense of a reclaiming creditor? Or stated differently, to the extent that these cases stand for the proposition that the rights of a reclaiming creditor under Section 546(c) of the Bankruptcy Code should hinge on the sequence in which a secured creditor's collateral is liquidated, is such a result equitable?

Should Marshalling Doctrine Apply to Preserve Reclamation Rights?

A plain reading of Section 546(c) states that the rights of a reclaiming creditor trump the rights of a trustee under Section 544(a). Section 546(c) provides:

“Except as provided in subsection (d) of this section, the rights and powers of a trustee under sections 544(a), 545, 547, and 549 of this title are subject to any statutory or common-law right of a seller of goods that has sold goods to the debtor, in the ordinary course of such seller's business, to reclaim such goods if the debtor has received such goods while insolvent.”

What rights does a trustee have under Section 544(a)? Section 544(a) provides:

“(a) The trustee shall have, as of the commencement of the case, and without regard to any knowledge of the trustee or of any creditor, the rights and powers of, or may avoid any transfer of property of the debtor or any obligation incurred by the debtor that is voidable by – (1) a creditor that extends credit to the debtor at the time of the commencement of the case, and that obtains, at such time and with respect to such credit, a judicial lien on all property on which a creditor on a simple contract could have obtained such a judicial lien, whether or not such a creditor exists; (2) a creditor that extends creditor to the debtor at the time of the commencement of the case, and obtains, at such time and with respect to such credit, an execution against the debtor that is returned unsatisfied at such time, whether or not such a creditor exists; or (3) a bona fide purchaser of real property, other than fixtures, from the debtor, against whom applicable law permits such transfer to be perfected, that obtains the status of a bona fide purchaser and has perfected such transfer at the time of the commencement of the case, whether or not such a purchaser exists.”

Collier summarizes these rights by stating that “[u]nder subsection 544(a)(1), the trustee has the rights and the powers, as of the date of the commencement of the case, to avoid any transfer or obligation of the debtor that is avoidable by a hypothetical creditor on a simple contract with a judicial lien on the property of the debtor unsatisfied as of the date of the commencement of the case. The trustee also has the rights and powers, under subsection (a)(2), of a hypothetical creditor with a writ of execution returned unsatisfied at the date of the commencement of the case, and under subsection (a)(3) the trustee may avoid any lien or transfer avoidable by a hypothetical bona fide purchaser of real property of the debtor as of the date of the commencement of the case. Section 544(a) has been justly and characteristically termed the 'strong arm clause'.” See 5 Collier on Bankruptcy ' 544.02, at 544-4,5 (15th ed.). Collier concludes that these rights include the right to invoke the equitable doctrine of marshalling, stating “[t]he trustee as holder of a judicial lien has the ability to invoke marshalling.” See 5 Collier on Bankruptcy ' 544.07[2], at 544-14 (5th ed.).

Thus, if Section 544(a) provides that the rights of a trustee are subject to the rights of a reclaiming creditor under Section 546(c), may we conclude that the creditor also is able to invoke marshalling to protect its reclamation rights? After all, in a case involving an over-secured lender, marshalling should not ultimately affect the secured lender and will preserve the rights of a reclaiming creditor to recover on its claim ahead of general unsecured creditors. This result seems to foster the purposes of Section 2-702 and 546(c) by protecting the rights of a reclaiming creditor and also protects a fully secured lender — thereby achieving an equitable result for all interested parties.

Some courts deny relief under Section 546(c) of the Bankruptcy Code to a vendor holding a valid reclamation claim where a secured lender holds a floating lien on after-acquired inventory. In such cases, no administrative expense claim or replacement lien is granted to the vendor. This occurs even when the secured lender is oversecured. This article poses the question as to whether pursuant to Sections 544(a) and 546(c) of the Bankruptcy Code the equitable doctrine of marshalling should apply to provide relief to a reclamation creditor where a secured lender holding a lien on substantially all of the debtor's assets, including floating lien and after-acquired inventory, is oversecured. A plain reading of Sections 544(a) and 546(c) of the Bankruptcy Code suggests that a reclaiming creditor may be able to invoke the marshalling doctrine under these circumstances.

Split of Authority in Cases Involving Reclamation

Claims and Floating Liens in After-Acquired Inventory

There is a split of authority involving treatment of valid reclamation claims where a floating lien in after-acquired inventory is held by a secured lender.

Some cases simply hold that the vendor is entitled to a lien or an administrative priority claim for the amount of the goods sought to be reclaimed. These cases are based on the plain language of Section 546(c) which states that “the court may deny reclamation to a seller with such a right of reclamation…only if the court grants the claim of such a seller priority as a claim of a kind specified in section 503(b) of this title or secures such claim by a lien.” 11 U.S.C. ' 546(c). Thus, Section 546 (c) entitles a reclaiming creditor to an administrative expense priority or lien in the full amount of its reclamation claim.

Still other courts hold that a reclamation claim is subordinated to the floating inventory lien of the secured lender. However, in cases where the reclamation claim is subordinated the courts generally find that there is insufficient inventory value to fully satisfy the first-priority lien of the secured lender from the sale proceeds of inventory, thereby effectively rendering any reclamation claim valueless. In effect, these courts find that a reclamation claim is extinguishable whenever the inventory proceeds are paid to a secured creditor — even if the secured creditor is ultimately oversecured when all of its collateral is liquidated. See In re Arlco, 239 B.R. 261 (Bankr. S.D.N.Y. 1999, (vendor's reclamation claim was valueless because the proceeds of the debtor's inventory were insufficient to satisfy the secured lender even though secured lender was later found to be fully secured).

Is the protection that UCC Section 2-702 and Bankruptcy Code Section 546(c)(2) provide to reclaiming vendors being undermined and determined arbitrarily by the sequence in which collateral is liquidated?

By way of example, assume that a secured lender has a perfected lien on all of the debtor's assets, including a floating lien on after-acquired inventory and a lien on choses in action. Assume further that at the time a vendor made its reclamation demand, the debtor held an unliquidated claim against various officers and directors of the debtor for alleged misconduct. Further, assume that this litigation claim against former management (chose in action) is eventually settled during the bankruptcy case for several millions of dollars — but long after the debtor's inventory had been liquidated. Finally, assume that if the settlement proceeds were added to the balance sheet of the debtor at the time reclamation demand was made, the debtor would have had sufficient funds to pay all secured liens in full and to pay a dividend to unsecured creditors. It seems under these facts that the secured lender's lien in after-acquired inventory should not extinguish the reclamation claim, but according to some courts, it does.

Is this the right result? Should a reclaiming creditor be denied relief simply because inventory proceeds are usually paid to a secured lender first – even where the secured lender is ultimately found to be over-secured when the liquidation of all of its collateral has been completed? When should the rights of a reclaiming creditor be determined, at the time inventory is liquidated, after all of the secured lender's collateral is liquidated or at some other point in time?

Can it be argued that those cases which hold that a reclaiming creditor's right are either cut off or rendered valueless even where the proceeds of the secured party's collateral is sufficient to satisfy its lien in full are based upon the arbitrary sequence in which collateral is liquidated and create a windfall for unsecured creditors at the expense of a reclaiming creditor? Or stated differently, to the extent that these cases stand for the proposition that the rights of a reclaiming creditor under Section 546(c) of the Bankruptcy Code should hinge on the sequence in which a secured creditor's collateral is liquidated, is such a result equitable?

Should Marshalling Doctrine Apply to Preserve Reclamation Rights?

A plain reading of Section 546(c) states that the rights of a reclaiming creditor trump the rights of a trustee under Section 544(a). Section 546(c) provides:

“Except as provided in subsection (d) of this section, the rights and powers of a trustee under sections 544(a), 545, 547, and 549 of this title are subject to any statutory or common-law right of a seller of goods that has sold goods to the debtor, in the ordinary course of such seller's business, to reclaim such goods if the debtor has received such goods while insolvent.”

What rights does a trustee have under Section 544(a)? Section 544(a) provides:

“(a) The trustee shall have, as of the commencement of the case, and without regard to any knowledge of the trustee or of any creditor, the rights and powers of, or may avoid any transfer of property of the debtor or any obligation incurred by the debtor that is voidable by – (1) a creditor that extends credit to the debtor at the time of the commencement of the case, and that obtains, at such time and with respect to such credit, a judicial lien on all property on which a creditor on a simple contract could have obtained such a judicial lien, whether or not such a creditor exists; (2) a creditor that extends creditor to the debtor at the time of the commencement of the case, and obtains, at such time and with respect to such credit, an execution against the debtor that is returned unsatisfied at such time, whether or not such a creditor exists; or (3) a bona fide purchaser of real property, other than fixtures, from the debtor, against whom applicable law permits such transfer to be perfected, that obtains the status of a bona fide purchaser and has perfected such transfer at the time of the commencement of the case, whether or not such a purchaser exists.”

Collier summarizes these rights by stating that “[u]nder subsection 544(a)(1), the trustee has the rights and the powers, as of the date of the commencement of the case, to avoid any transfer or obligation of the debtor that is avoidable by a hypothetical creditor on a simple contract with a judicial lien on the property of the debtor unsatisfied as of the date of the commencement of the case. The trustee also has the rights and powers, under subsection (a)(2), of a hypothetical creditor with a writ of execution returned unsatisfied at the date of the commencement of the case, and under subsection (a)(3) the trustee may avoid any lien or transfer avoidable by a hypothetical bona fide purchaser of real property of the debtor as of the date of the commencement of the case. Section 544(a) has been justly and characteristically termed the 'strong arm clause'.” See 5 Collier on Bankruptcy ' 544.02, at 544-4,5 (15th ed.). Collier concludes that these rights include the right to invoke the equitable doctrine of marshalling, stating “[t]he trustee as holder of a judicial lien has the ability to invoke marshalling.” See 5 Collier on Bankruptcy ' 544.07[2], at 544-14 (5th ed.).

Thus, if Section 544(a) provides that the rights of a trustee are subject to the rights of a reclaiming creditor under Section 546(c), may we conclude that the creditor also is able to invoke marshalling to protect its reclamation rights? After all, in a case involving an over-secured lender, marshalling should not ultimately affect the secured lender and will preserve the rights of a reclaiming creditor to recover on its claim ahead of general unsecured creditors. This result seems to foster the purposes of Section 2-702 and 546(c) by protecting the rights of a reclaiming creditor and also protects a fully secured lender — thereby achieving an equitable result for all interested parties.