Restructuring

Contributed by Sara Coelho
For a Throwback Thursday, we often go way back, to cases establishing first principles. This time, however, we travel not so far back, but still to a bygone era, the early 80’s. It was a time when the Bankruptcy Code was still new, and judges could interpret it without the weight of much practice and precedent. Often, these cases present the starting point for familiar interpretations that continued to develop in later years, but other times it’s surprising to see a new interpretive opening that, years later, is not thoroughly explored. The recognition of stoppage rights against debtors in possession pursuant to the Uniform Commercial Code in In re National Sugar Refining Company is such an instance. There, the District Court for the Southern District of New York recognized that the UCC rights of a seller of goods to stop delivery trump the passage of title of goods in question to the debtor and the automatic stay. Does the court’s logic tell us anything about whether the Bankruptcy Code may preserve other UCC rights?
In National Sugar, a seller of sugar exercised its right of “stoppage in transit” against a chapter 11 debtor buyer, which means it intervened to stop the shipment of goods, in this case sugar, to the debtor after the automatic stay took effect. Title to the sugar passed to the debtor prepetition, when the seller notified the buyer of its shipment of the sugar pursuant a contract between the parties. The debtor likened the seller’s stoppage rights to a lien and asserted that the Bankruptcy Code allowed it to avoid whatever interest arose in favor of the seller as a result of the stoppage right. Another secured creditor (implicitly a bank with a lien on the sugar) also asserted an interest in the sugar superior to that of the seller. The bankruptcy court allowed the seller to stop the shipment and sell the sugar on the open market, pending determination of whether the bank or the sugar seller were entitled to the proceeds of the sale, and the debtor appealed.
The UCC allows a seller of goods to stop delivery of goods in transit under certain circumstances. Under UCC 2-702(1), where a seller of goods “discovers the buyer to be insolvent he may refuse delivery except for cash including payment of all goods theretofore delivered under the contract, and stop delivery under this Article (Section 2-705).” UCC 2-705(1) provides that a “seller may stop delivery of goods in the possession of a carrier or other bailee when he discovers the buyer to be insolvent . . . or if for any other reason the seller has a right to withhold or reclaim the goods.” The right of stoppage is cut off by, among other things, receipt of the goods by the buyer.
In the words of the National Sugar court, the right is “premised on the inequity of permitting the buyer to obtain possession of goods when there has been a prospective failure of the buyer’s performance.” Instead of trying to enforce payment against an insolvent buyer, the seller may suspend performance “until and unless he is assured of the buyer’s payment in cash upon delivery, even though the contract may call for the extension of credit.” The official comment to the UCC clarifies that the suspension is temporary and does not excuse performance. It says, “Where stoppage occurs for insecurity it is merely a suspension of performance, and if assurances are duly forthcoming from the buyer the seller is not entitled to resell or divert.” Note that, because a seller’s rights following stoppage are equivalent to rights when a seller withholds delivery, the court found that it was immaterial whether goods were actually stopped in transit or whether the seller withheld delivery. In either case, title may have transferred to a buyer and become part of a bankruptcy estate.
The debtor argued that (i) the stay prohibited exercise of stoppage rights, (ii) instead of allowing stoppage and disposition of the sugar, the bankruptcy court should have compelled assumption or rejection of the sugar contract, which was technically the only relief requested by the sugar seller, and (iii) under sections 544 and 545 of the Bankruptcy Code, the debtor had the right to avoid whatever interest arose because of the seller’s stoppage rights.
The court rejected the debtor’s argument that the exercise of stoppage rights violated the automatic stay. Because it found, for the reasons described below, that a seller has a right of stoppage under the Bankruptcy Code, it didn’t consider whether the stoppage right violates the stay and is prohibited per se as an act to obtain possession of estate property. Instead, it considered whether the stay requires a seller to seek stay relief before exercising a stoppage right and concluded that the practical effect of such a requirement would deny the seller its stoppage right because of the usually short time in which the right may be exercised before receipt of the goods by the buyer occurs and cuts off the right. It analogized stoppage to making a written demand for reclamation, an action expressly permitted by the Bankruptcy Code, notwithstanding the automatic stay. It distinguished stoppage from disposition of the goods, however, which presumably can occur only after relief from the stay.
The court remanded on the debtor’s argument that the bankruptcy court should have ruled only on whether the debtor was compelled to assume or reject the contract for determinations of whether the debtor waived the argument, and further consideration if the argument was not waived. It did say, however, that granting the seller the “right effectively to cancel the sugar contracts and to dispose of the sugar needed to have been predicated on an order requiring either assumption or rejection followed by [the debtor’s] rejection of the contracts; or assumption by [the debtor] negated by the failure to provide assurances of performance . . . .” Otherwise, the court held, the debtor was not yet required to assume or reject the contract or prove that it could perform, and it was “denied its rights by the court allowing [the seller] to sell the sugar and litigate only with [the bank] over proceeds.” From the court’s discussion, it appears that, although this court would allow a seller to stop shipment of goods in transit without relief from the court, it would require a seller to move to compel assumption or rejection of any contract governing the sale, and possibly relief from the stay, before exercising any further rights.
The court rejected the debtor’s arguments that the stoppage right created a seller’s lien, avoidable by the debtor under sections 544(a) and 545 of the Bankruptcy Code. Section 544(a) allows the debtor in possession to avoid liens that are avoidable by a certain types of hypothetical creditors and purchasers, whether or not such a creditor or purchaser exists, and therefore may be used to avoid unperfected liens. Section 545 allows the debtor to avoid unperfected liens that arise by statute upon the debtor’s insolvency. The debtor argued that, because the seller had not exercised its stoppage right on the petition date, the seller had, in effect, either a simple unsecured claim or a statutory lien subject to avoidance under section 545.
As an initial matter, the court was skeptical that stoppage rights create a lien at all. It quoted one treatise holding that, because the “seller’s lien,” although a part of pre-UCC law, does not appear in the UCC, it “presumably no longer exists.” The safe harbor from avoidance of reclamation rights under section 546(c) of the Bankruptcy Code was more decisive in the court’s interpretation, however. Section 546(c) exempts reclamation rights, including those under the UCC, from the debtor’s powers, subject to certain time limits and procedures.
UCC 2-702(2) provides sellers with a right to reclaim delivered goods. This provision immediately follows, the section allowing for withholding of delivery and stoppage. The court found it improbable that Congress would, in drafting the Bankruptcy Code, have provided greater rights to a seller who delivered goods — by preserving its UCC reclamation right in bankruptcy — than one who withheld or stopped delivery. It stated that both affect the same interest of the debtor/buyer, namely, “defeasible” (i.e., subject to annulment) title, found no authority for the notion that stoppage rights create lien interests, and cited some commentary indicating that bankruptcy courts allowed exercise of stoppage rights against a debtor under the former Bankruptcy Act. On the other hand, under the former Bankruptcy Act, the existence of conflicting caselaw on the exercise of reclamation rights against a debtor created the need for clarification and consistency when Congress passed the Bankruptcy Code. Accordingly, the court found that, had Congress considered whether to allow stoppage rights to be impinged by the Bankruptcy Code, its treatment of reclamation rights indicates that it “would likewise have recognized the validity of a seller’s right of stoppage as against a debtor-in-possession.”
The recognition of a stoppage right after passage of title to a debtor in possession, notwithstanding the automatic stay, is somewhat troubling, as it allows a vendor to exercise control over estate property and potentially allows it to extract payment for claims arising prepetition pursuant to the UCC (and likely a critical vendor motion) or by forcing an early assumption. This is a dynamic on which courts seem to studiously avoid commenting. Consider, however, that the effect of these rights is to permit a vendor to effectively deny a debtor credit, not goods, and to give the vendor a degree of security when dealing with an insolvent buyer. Debtors can obtain the goods if they can provide the vendor with payment or assurance, relief a bankruptcy court might also fashion under the Bankruptcy Code. The practice of entering a first day order assuring vendors that payments for goods delivered postpetition will be treated as administrative expenses is consistent with the principles of National Sugar. Moreover, after adoption of section 503(b)(9) of the Bankruptcy Code under BAPCPA, sellers of goods hold administrative expense priority claims for the value of goods received by the debtor within the 20 days immediately preceding the filing of the bankruptcy petition.
Perhaps the most surprising result is that, after the ease with which the National Sugar court swallowed exercise of stoppage rights against a debtor in possession, parties have not extensively tested exercise of all forms of UCC remedies against a debtor, and it is still sometimes unclear how UCC and bankruptcy rights operate together. For example, as described above, the National Sugar court found no distinction in the position between a vendor exercising stoppage rights and a vendor withholding delivery. Does that mean that it would allow a vendor to withhold delivery in the course of exercising other UCC rights? An earlier post describes limited caselaw and questions on the scope of a seller’s UCC rights regarding adequate assurance. One might argue that the reasoning in the National Sugar case preserves other UCC rights not specifically overridden by the Bankruptcy Code and allows exercise of such rights where the effect is only to temporarily suspends a seller’s performance or preserve a seller’s position while it obtains relief in the bankruptcy court enabling it to exercise more permanent remedies. Such a concept would provide some guidance to parties, but the case itself does not step back and articulate such broad guiding principles.