The Bottom Line
In Whirlpool Corp. v. Wells Fargo Bank (In re hhgregg Inc.), Case No. 18-3363 (7th Cir. Feb. 11, 2020), the Seventh Circuit held that a trade creditor’s later-in-time reclamation claim was subordinate to lenders’ pre-petition and debtor-in-possession (“DIP”) financing liens. The Seventh Circuit found that Sction 546(c) of the Bankruptcy Code creates a “federal priority rule,” making clear that a reclamation claim is subordinate to prior rights of a secured creditor.
What Happened?
Hhgregg Inc. is an appliance retailer that, along with two related companies (the “Debtors”), filed for Chapter 11 bankruptcy on March 6, 2017. In the years prior to bankruptcy, Wells Fargo Bank (“Wells Fargo”), as administrative agent for several lenders, extended the Debtors’ financing, secured by a first-priority floating lien on nearly all assets, including existing and after-acquired inventory and proceeds. As of the petition date, the Debtors owed Wells Fargo at least $66 million.
On March 7, the Debtors obtained bankruptcy court interim approval for $80 million in DIP financing (the “March 7 Interim DIP Order”), which included a “roll-up” of the secured lenders’ pre-petition debt and gave Wells Fargo (acting as administrative agent for the DIP lenders) a priming first-priority lien on the Debtors’ assets, including existing and after-acquired inventory and proceeds. The DIP financing was approved on a final basis on May 2, at which point the pre-petition secured debt was paid in full pursuant to the roll-up in the March 7 Interim DIP Order.
On March 10, three days after the Debtors had obtained interim approval of their DIP financing, Whirlpool Corporation (“Whirlpool”) — which delivered appliances on credit for resale in the Debtors’ retail stores — sent the Debtors a reclamation demand seeking the return of approximately $16.3 million of unpaid inventory it had delivered within 45 days of the petition date.
By way of background, reclamation is an in rem remedy that allows a seller to recover possession of goods delivered to an insolvent purchaser on credit. Section 546(c) of the Bankruptcy Code governs reclamation in bankruptcy. Under Sction 546(c), 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.”
Whirlpool filed an adversary action against Wells Fargo seeking a declaration that its reclamation claim was first in priority as to the reclaimed goods. Among other things, the complaint alleged that Wells Fargo had not acted in good faith. Wells Fargo moved to dismiss. The bankruptcy court concluded that the 2005 amendments to the Bankruptcy Code (“BAPCPA”) — in particular to Sction 546(c) — render an otherwise valid reclamation claim under state law subordinate to a secured creditor’s prior lien rights. When Whirlpool made its reclamation demand, the goods at issue were encumbered by Wells Fargo’s prior interests; hence, the bankruptcy court found that Whirlpool’s claim was subordinate. The district court affirmed and Whirlpool appealed.
Like the bankruptcy court, the Seventh Circuit considered the right of reclamation both outside and within bankruptcy. Under U.C.C. § 2-702, the right to reclaim goods is subject to temporal and procedural requirements and the rights of buyers in the ordinary course and other good-faith purchasers. Within bankruptcy, as originally enacted, section 546(c) did not address the effect of a prior lien on a reclaiming seller’s rights. Thus, pre-BAPCPA, bankruptcy courts struggled to resolve conflicts between reclaiming sellers under section 546(c) and the claims of secured lenders holding floating liens on inventory. The Seventh Circuit stated that BAPCPA addressed these conflicts with its amendments to Sction 546(c). Among other things, the amendments added explicit language 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.”
The Seventh Circuit concluded that section 546(c) makes “crystal clear that a seller’s reclamation claim is subordinate to ‘the prior rights of a holder of a security interest’” (citing 11 U.S.C. § 546(c)(1)). Accordingly, the Seventh Circuit found that under the terms of the DIP financing and effective upon entry of the March 7 Interim DIP Order, Wells Fargo obtained a priming, first-priority security interest in the Debtors’ assets, including the Whirlpool inventory. Since Whirlpool’s reclamation demand was three days later, it was “subject to” Wells Fargo’s prior rights.
Whirlpool argued that it was not the date of its demand that mattered, but rather that its reclamation claim was “in effect” on the petition date, such that its claim “jumped into first position” in between the petition date and March 7 and then jumped ahead of the DIP lien when the pre-petition lien was extinguished in the roll-up. The Seventh Circuit disagreed. First, a reclamation right is not a security interest and is not self-executing; thus, it was not “in effect” on March 6. Second, there was no gap in Wells Fargo’s lien chain. The court found that Whirlpool’s reclamation claim did not jump to first position when the pre-petition lien was satisfied in the roll-up: When the reclamation claim was made on March 10, the goods were subject to Wells Fargo’s pre-petition and DIP financing liens.
Finally, the Seventh Circuit rejected Whirlpool’s alternative argument that prior rights of a secured creditor must be determined by state law. Under the current Sction 546(c), the court found no need or reason to engage in a state-law good faith purchaser inquiry. Accordingly, Whirlpool’s allegations of bad faith were irrelevant for a priority determination under section 546(c).
Why This Case Is Interesting
The Seventh Circuit found that it was “crystal clear” that post-BAPCPA, a seller’s reclamation claim is subordinate to prior rights of secured creditors, irrespective of whether the secured creditor would be considered a good faith purchaser under state law. As the Seventh Circuit observed, as a practical matter, the “federal priority rule” created by Sction 546(c) means that if the value of a reclaiming seller’s goods is less than the amount of debt secured by the prior lien, its reclamation claim is valueless. Trade creditors will need to be vigilant in protecting potential reclamation claims by sending reclamation demands as soon as possible and potentially objecting to DIP financing that includes roll-ups of pre-petition debt (though Whirlpool had filed a limited objection to the interim DIP, referring to its reclamation claim). The date on which the reclaiming seller’s demand is made is critical to determining its priority.
