Bankruptcy: How do Secured and Unsecured Creditors Get Paid

In bankruptcy, a creditor’s rights are defined by the United States Bankruptcy Code. If you have a client that is a secured or unsecured creditor in a bankruptcy, the important question is where your client stands in line.

Secured creditors are in the best position, because they will usually get back their collateral or the value of it. Next are priority unsecured creditors, who have claims that the Bankruptcy Code affords special protection (i.e., child support, certain kinds of taxes). At the very end of the line, are the general unsecured creditors. This is the worst place to be. After all, if the debtor had enough money to pay unsecured creditors, they likely would not be in bankruptcy in the first place.

Unsecured creditors in bankruptcy rarely get paid, but not always. The Bankruptcy Code grants certain sellers of goods the right to either reclaim the goods they sold or receive full payment for their value, in the form of an administrative claim against the bankruptcy estate. Such an administrative claim is a better position than almost any secured or unsecured creditors, because sellers are essentially brought to the front of the line. In short, qualifying sellers of goods moves to the top of the bankruptcy food chain, even though they are still unsecured creditors.*

Rights of Sellers of Goods

The Bankruptcy Code contains two remedies for secured and unsecured creditors who sold goods to a debtor in the ordinary course of business shortly before the debtor filed bankruptcy. First, 11 U.S.C. § 546(c) allows sellers to reclaim goods that the debtor received within the 45 days prior to the commencement of the bankruptcy, provided that the debtor was insolvent when it received them. Most courts agree that this right is a recognition and expansion of a seller’s reclamation rights under the Uniform Commercial Code, rather than the creation of a federal right to reclaim sold goods.

Moreover, the seller’s right is not self-executing. To reclaim sold goods, the seller must first make a written demand on the debtor no later than 45 days after the goods were delivered or, if the 45 days expires after the bankruptcy was filed, within 20 days after the commencement of the bankruptcy. A creditor can only reclaim those goods that the debtor did not resell to a customer, and only from a debtor that was insolvent when it received the goods, as defined under bankruptcy or applicable non-bankruptcy law. If the seller cannot meet one or more of these factors, it cannot reclaim its goods. Finally, the automatic stay must be modified or lifted to allow the seller to physically reclaim the property from the trustee or debtor in possession.

The second creditor remedy is found in 11 U.S.C. § 503(b)(9) of the Bankruptcy Code, which allows a seller an administrative claim for the value of any goods of the seller that the debtor received within 20 days prior to the bankruptcy filing. Unlike a seller’s reclamation right, a seller is not required to prove that the debtor was insolvent at the time it received the goods, nor is the seller required to do anything other than file a timely proof of claim, and prove the debtor received the goods within the relevant time frame, if necessary.

Perhaps most importantly, the administrative claim puts the seller at or near the top of the creditor food chain, creating for the seller the right to take at least the value of the goods received by the debtor in the 20 days prior to filing. An administrative claim is also a priority claim under 11 U.S.C. § 507(a)(2). When filling out a proof of claim, a seller should denote the administrative portion of the claim as a priority in box number 5 of the proof of claim.

The code gives a seller having a right to reclamation the choice to have his or her claim treated as an administrative claim under § 503(b)(9), even if the seller did not timely notice the debtor or trustee of its reclamation right. The offsetting consideration is that the seller is likely giving up the right to 45 days worth of goods for 20 days worth of money.* Timing plays an important role in determining whether to reclaim the goods or request an administrative claim for value.

A seller should also consider the type of bankruptcy the debtor filed. A
debtor that files a chapter 11 may pay its vendors the full value of a claim over time, rather than just the value of a portion of the goods, because it wants to remain commercially viable. Conversely, a trustee administering the assets of a bankrupt business will only pay what it is required under the Code.

In most bankruptcy cases, non-priority, unsecured creditors receive little or nothing from the estate. Qualifying sellers of goods escape this result by using provisions of the Bankruptcy Code designed to protect them. These provisions help sellers get some value for the goods they sold.

Williams Baird (2014 May 3) Bankruptcy: How do Secured and Unsecured Creditors Get Paid. Retrieved on May 27, 2014 From bwglaw.net