Double Duty: UCC Definition of Goods Same for ' 503(b)(9)

As most practitioners know, the Bankruptcy Code imposes a specific priority scheme that controls the payment of claims. The higher the priority of a particular claim, the more likely it is to be paid. Generally, secured claims are paid first from the specific collateral backing that claim, followed by administrative priority claims, unsecured priority claims and then general unsecured claims. Equity takes last, assuming there is anything left.

In 2005, Congress amended the Bankruptcy Code to add ' 503(b)(9), which dramatically changed the payment priorities and, as a result, Chapter 11 itself. Section 503(b)(9) provides for the allowance of an administrative claim for the “value of any goods received by the debtor within 20 days before the date of commencement of a case under [Title 11] in which the goods have been sold to the debtor in the ordinary course of such debtor's business.” Thus a large body of claims that were formerly treated as general unsecured now receive administrative priority. Because a plan (the vehicle for a debtor to successfully exit Chapter 11) must pay administrative claims in full in order to be confirmed, many debtors are now entering Chapter 11, selling their assets and immediately converting to a Chapter 7 liquidation.

Aggressive Challenges

Some debtors, instead of simply giving up, however, are mounting aggressive challenges against ' 503(b)(9) claims. For example, the Chapter 11 debtor in the bankruptcy case In re Circuit City Stores Inc., involving the former consumer electronics giant, Circuit City, recently sought a ruling that the term “goods,” as used in ' 503(b)(9), should carry the same narrow definition as set forth in the Uniform Commercial Code. The debtor in the same case asked the court to rule that in transactions involving both the sale of goods and the provision of services, the “predominant purpose” test should be employed to determine whether the ' 503(b)(9) priority applies. By doing so, the debtor had hoped to dramatically reduce the overall number of administrative priority claims.

The Definition of 'Goods'

The Circuit City court first addressed the definition of “goods” for purposes of ' 503(b)(9). In doing so, it noted that the Bankruptcy Code contains no definition of the term and there was no controlling law in the Fourth Circuit. Consistent with the practice in the Fourth Circuit, the bankruptcy court then turned to state law and concluded that the UCC should be employed to fashion a definition for the same term in ' 503(b)(9). The court noted using the UCC definition would give a consistent, uniform approach, since 49 states had already adopted some version of the UCC.

UCC ' 2-105(1) defines goods as “all things (including specially manufactured goods) which are movable at the time of identification to the contract for sale other than the money in which the price is to be paid ' .” The bankruptcy court noted that this is consistent with the definition in Black's Law Dictionary and with the term's ordinary and common usage ' it is the “well-known meaning” of goods.

The court also found support for using the UCC definition from the fact that ' 503(b)(9) is itself part of a section titled “Reclamation” within the 2005 amendments to the Bankruptcy Code. According to the Seventh Circuit, reclamation, which allows sellers to take back goods delivered to buyers under certain circumstances, “arises under ' 2-702 of the UCC.” (See In the Matter of Adventist Living Centers Inc.) Given that reclamation has its origins in the UCC, which defines “goods,” and that Congress did not choose to provide a different definition in the Bankruptcy Code, the court reasoned that the UCC definition was likely intended to apply to the Bankruptcy Code as well.

The 'Predominant Purpose Test'

As to the second issue under '503(b)(9), the Circuit City court concluded that the “predominant purpose test,” developed and applied by the majority of courts to determine whether the UCC is applicable to hybrid contracts calling for the delivery of both goods and services, should be used to determine whether a claim is entitled to administrative priority under ' 503(b)(9). Under this test, the court must determine whether “the sale of the goods predominates.” (See BMC Industries Inc. v. Barth Indus Inc.) In so ruling, the court looked with favor upon the formulation of the predominant purpose test set forth in Princess Cruises Inc. v. General Electric Co., quoting Bonebreak v. Cox, which provided, “[T]he test for inclusion or exclusion is not whether they are mixed but, granting that they are mixed, whether their predominant factor, their thrust, their purpose, reasonably stated, is the rendition of service, with goods incidentally involved (e.g., contract with artist for painting) or is a transaction of sale, with labor incidentally involved.”

In an Oct. 7 memorandum ruling arising out of In re SemCrude, pending in Wilmington, DE, the court addressed, among a number of issues, the measurement of “value” under ' 503(b)(9). In SemCrude, it was argued by the bank agent opposing the '503(b)(9) claims that the term “value” for purposes of measuring the size of a 20-day claim should be “the resale price of goods, or if the goods were not resold, the current market value of the goods on the Effective Date of the Plan.” Not surprisingly, many of the vendors argued that the “value” of the goods was established by the invoice or contract price. Judge Brendan Linehan Shannon, while recognizing that the term “value” is not defined within the Bankruptcy Code, found that “there is ample and convincing authority to support the proposition that the invoice or purchase price is presumptively the best determinant of value.” The court went on to note, however, that such price could be rebutted under the particular facts and circumstances of a given transaction.

Conclusion

Until the circuit courts (and possibly the Supreme Court) rule on these and many other issues arising under ' 503(b)(9), this Bankruptcy Code provision will remain a flash point given the enormous impact it will have on a debtor's ability to reorganize. For now, we can expect many more creative arguments to be advanced by debtors seeking to successfully emerge from Chapter 11.