Seventh Circuit Holds that Reclamation Claims are Statutorily Subordinate to Prior Floating Liens on Inventory
In Whirlpool Corporation v. Wells Fargo Bank, N.A., et al. (In re hhgregg, Inc.), No. 18-3363 (7th Cir. Feb. 11, 2020), the Seventh Circuit Court of Appeals recently held that the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA“) created a federal priority rule rendering a secured lender’s first-priority, floating liens on inventory superior to the reclamation claims of a trade vendor. The facts in the case are typical, and the holding does not mark a demonstrative shift in common practice.
The debtor was an appliance retailer. Within 45 days of its bankruptcy, a long-time supplier (Whirlpool Corporation) sold and delivered home appliances to the debtor for resale. Prepetition the debtor maintained a secured credit facility with a group of lenders (lead by Well Fargo Bank, N.A.), which held first-priority liens on virtually all of the debtor’s assets, including existing and after-acquired inventory and its proceeds. The debtor owed approximately $66 million to the prepetition secured lenders under this facility.
Postpetition the prepetition secured lenders extended the debtor an $80 million postpetition financing facility, which rolled-up their prepetition secured debt into the DIP facility and granted the secured lenders a priming, first-priority lien on existing and after-acquired inventory and its proceeds. The bankruptcy court approved this DIP financing instantly upon the bankruptcy filing.
After the debtor’s filing and after the DIP financing was approved, Whirlpool sent the debtor a timely $16.3 million reclamation demand for the goods supplied to the debtor just prior to the filing.
Reclamation claims are governed, in large part, by section 546(c) of the Bankruptcy Code. Before BAPCPA most bankruptcy courts applied a “prior lien defense” drawn from the Uniform Commercial Code’s substantive limitations on the reclamation remedy, subordinating a seller’s reclamation claim to a secured lender’s floating lien on a borrower’s inventory. According to the Seventh Circuit, BAPCPA adopted that state norm as a federal priority rule, by specifically providing that a seller’s right to reclaim goods is “subject to the prior rights of a holder of a security interest in such goods or the proceeds thereof.” 11 U.S.C. § 546(c).
The Seventh Circuit thus held that in the hhgregg case the DIP lenders’ first-priority liens on the debtor’s existing and after-acquired inventory and its proceeds trumped Whirlpool’s later-in-time reclamation demand.
Whirpool argued that its reclamation claim was in effect as of the bankruptcy filing and jumped into first position when the prepetition secured debt was rolled up into the DIP loan. The Seventh Circuit found, however, that the supplier’s reclamation claim did not exist absent a written reclamation demand, which, in this case, occurred after the bankruptcy court approved the DIP facility and granted first-priority, priming liens to the DIP lenders. The Court also found that the reclamation claim could not have come prior to the DIP lenders’ liens, because such liens existed under the prepetition credit facility prior to the goods being delivered by Whirpool and (b) continued undisturbed through the court-approved roll-up of the prepetition secured debt.
While the 2005 amendments to the Code did not change common practice in large chapter 11 cases with respect to subordinating reclamation claims to senior liens, it did arguably make it easier for prepetition secured lenders to maintain their first-priority positions despite competing claims. As a practical matter, the new federal priority rule created by BAPCPA means that if the value of any given reclaiming supplier’s goods does not exceed the amount of debt secured by a prior lien, the reclamation claim is valueless. This will generally occur when the prepetition secured lenders (with floating liens on inventory) are undersecured. Reclamation claimants will thus need to find other avenues to protect their reclamation rights (perhaps through section 503(b)(9) of the Code) in cases where a debtor has pre-existing floating liens on inventory.