(Creative commons licensed from flickr user kenteegardin.)

 In today’s volatile marketplace, it’s not uncommon for suppliers to be caught off guard after shipping product on normal credit terms and learning soon thereafter, or indirectly through the news media, that a long-time customer has filed for bankruptcy protection.

After trying to recover from the shock of the chain of events, the logical question becomes: Does a business have any hope of recovering payment on goods shipped to an insolvent customer?

Alas, vendors do have certain limited rights under the concept of reclamation, which can be used to retrieve the actual goods or obtain payment under certain conditions if specific procedures are followed.  In order to take advantage of reclamation, vendors must be vigilant and understand the potential pitfalls in attempting to recover payment or reclaim goods.

Outside of bankruptcy, vendors are afforded some protection under the Uniform Commercial Code (Section 2-702).  This provision, adopted by all states, provides that when an unpaid seller of goods discovers that a buyer was “insolvent” at the time of delivery of goods, the creditor may reclaim the goods upon demand made within 10 days after the receipt by the buyer of the goods. 

If the debtor/customer misrepresented his or her solvency in writing within three months before delivery, then the 10-day limitation does not apply.  Under the UCC, insolvency is defined as when the customer has ceased to pay the debts in the ordinary course of business, other than as a result of a bona fide dispute, or being unable to pay the debts as they become due.

Limitation on reclamation

 If the customer financed its operations through a lender which holds a valid security interest in the goods, then the reclamation claim is subject to the lender’s rights under state law.  Additionally, if the goods delivered are no longer in the possession of the buyer, the right of reclamation is lost.  A reclaiming vendor’s rights are also subject to the rights of a subsequent buyer who, in the ordinary course of business, purchases the merchandise in good faith from the customer of the reclamation vendor.  Thus, the reclaimed goods cannot be chased into the hands of a subsequent good faith purchaser.

After filing a bankruptcy petition, vendors must look to their rights under the United States Bankruptcy Code.  The Code permits a vendor to make a written reclamation demand for goods transferred to a debtor/customer in the 45 days (after the receipt of goods) immediately preceding the Chapter 11 filing.  If the 45-day period expires after the bankruptcy filing, the vendor has an additional 20 days to make a demand – thereby providing up to 65 days to recover goods from a bankrupt customer.

These deadlines are fixed and failure to strictly adhere to them jeopardizes the vendor’s rights to recover payment.

Process of exercising right of reclamation

The contents and delivery of a reclamation demand are critical. A demand letter should be sent via fax, overnight courier, certified mail to leave a paper trail. The letter also should be addressed to a specific person — preferably an officer at the company’s headquarters with a copy to counsel, if known.  A copy should be sent to the address where the goods were shipped. 

The letter should state that it is a demand for reclamation rights, pursuant to “Section 2-702 of the Uniform Commercial Code” or, in the event of a bankruptcy, “Section 546 of the Bankruptcy Code and applicable state law.”  The demand should identify the goods shipped, date shipped and destination.  Supporting documentation should be included — invoices, proof of shipment, etc.  The demand can also include a request for an accounting and inventory of what product is on hand.  The demand can also include a request that the goods be immediately segregated until suitable arrangements are made for their return. 

 To the extent that a timely written reclamation notice has not been provided, all hope is not lost.  The bankruptcy law permits vendors with the right to assert an administrative expense claim, which has a higher priority in the  order of payment of claims.  The law permits vendors to seek the “value” of any goods received by the debtor within 20 days before the date of commencement of a bankruptcy case.  The right to such favorable treatment, however, is not automatic as an administrative claim can only be allowed after “notice and hearing” before the bankruptcy court. 

Predictably, a debtor and vendor (as well as a secured creditor and creditors’ committee) may not see eye to eye on this standard.  For instance, a dispute over the interpretation of “value” and “goods” often arises which remain subject to potentially costly litigation and judicial determination.

Given the dynamics of the marketplace, the possibility of payment or recovery of goods delivered to an insolvent customer can be quite challenging. 

There are remedies available which, if properly adhered to procedurally, may enhance recovery.  In bankruptcy, vendors have the opportunity to receive favorable treatment if they become actively involved in the early phases of a case and are cognizant of the potential pitfalls that may lie ahead.

Peter E. Shapiro is a partner in the Fort Lauderdale office of Arnstein & Lehr LLP and a member of the firm’s bankruptcy group.