Sears Fights with Vendors Whether Goods Were Delivered Prepetition or Postpetition

Several foreign suppliers are seeking to compel payment by Sears Holding Corporation and subsidiary debtors (collectively the “Debtors”) for merchandise purchased by the Debtors during, or just before the commencement of, the Debtors’ Chapter 11 bankruptcy cases (the “Case” or “Sears”) pending in the United States Bankruptcy Court for the Southern District of New York (the “Court”). How these disputes are resolved will be important not only for Sears creditors, but more generally for suppliers of goods, merchants, and purchasers and sellers of bankruptcy trade claims.

Apex Tool Group, LLC, Winners Industry Co., Gokaldas Exports Ltd. and Pearl Global Industries Ltd., among others (collectively the “Vendors”), have filed papers in the Case (i) objecting to the Debtors’ disclosure statement relating to the Debtors’ proposed chapter 11 plan and (ii) arguing that goods they shipped to Sears are entitled to treatment as administrative expense claims. Although the particular details vary somewhat, each Vendor is based in Asia and generally shipped goods on credit in fulfillment of orders placed by the Debtors, some of which occurred before the petition date of October 15, 2018 (“Petition Date”). Generally, administrative expense claims must be paid in full in cash in order for a Chapter 11 plan to be confirmed.

The crux of the dispute between the Vendors and the Debtors is when the goods are deemed to have been delivered. Goods shipped from Asia often take several weeks to arrive, and therefore an order placed prepetition may not be shipped or delivered until after the petition date.

The Vendors assert that the Debtors took physical possession of the goods either after the Petition Date or within twenty days before the Petition Date, and therefore their claims should be treated as administrative expense claims under Section 503 of the Bankruptcy Code. The Debtors argue that a claim arises when a creditor has satisfied its obligations and transferred title to the Debtors (e.g. when the Vendor delivered the goods to a common carrier, title to the goods and the risk of loss generally passed to the Debtors), rather than the later date when the goods are received.

The difference is significant because, if the Debtors prevail, the Vendors’ claims will be treated as prepetition general unsecured claims and receive substantially less in distributions than administrative expense claims – and in Sears there are concerns that the estate may be, or could become, administratively insolvent (meaning generally no distributions to prepetition creditors). If the Vendors prevail, the Debtors worry that the estate would incur significant additional administrative expenses to the detriment of thousands of other creditors.

Resolution of the disputes will turn on a number of factors, including the facts relevant to each Vendor’s arrangements with the Debtors. Conceivably the parties, with or without the encouragement of the Court, may find a consensual resolution or decide to postpone, at least temporarily, their litigation. Ultimately however the parties and the Court will have to grapple with their respective facts in the context of the Final Shipping Order (defined below) in the Case as well as Sections 503(b)(1)(A) and 503(b)(9) of the Bankruptcy Code.

On November 20, 2018, the Court entered an order[1] (the “Final Shipping Order”) providing in part that “[a]ll undisputed obligations of the Debtors arising from the postpetition delivery or shipment by of [sic] under the Prepetition Orders are granted administrative expense priority status pursuant to section 503(b)(1)(A) of the Bankruptcy Code, and the Debtors are authorized, but not directed, to pay such obligations in the ordinary course of business consistent with the parties’ customary practices in effect prior to the Commencement Date.” Final Shipping Order ¶ 8. The Final Shipping Order also provides that “nothing [t]herein shall create … any rights in favor of, or enhance the status of any claim held by any party.” Final Shipping Order ¶ 12.

Section 503(b)(1)(A) of the Bankruptcy Code provides that, “after notice and a hearing, there shall be allowed administrative expenses … including the actual, necessary costs and expenses of preserving the estate.” In general, the claim of a creditor providing goods or services to the debtor during its bankruptcy case is entitled to administrative expense treatment.[2]

Bankruptcy Code Section 503(b)(9) provides that “the value of any goods received by the debtor within 20 days before the commencement of a case … in which goods have been sold to the debtor in the ordinary course of such debtor’s business” will be entitled to treatment as an administrative expense claim.

Of potential relevance to the disputes between the Vendors and the Debtors, in 2017 the United States Circuit Court of Appeals for the Third Circuit held that the word “received” as used in Section 503(b)(9) means the date on which the debtor had physical possession of the goods in question.[3]

On May 15, 2019 the Debtors filed their Omnibus Objection to Vendors’ Motions for Allowance and Payment of Administrative Expense Claims [Dkt. 3883] (the “Omnibus Objection”). In the Omnibus Objection the Debtors argue, among other things, that (i) the time of arrival of the shipment is not the standard for Section 503(b)(1), (ii) World Imports is not applicable to 503(b)(1) claims, (iii) the Vendors are not entitled to 503(b)(1) priority, (iv) discovery would be required, and (v) 503(b)(9) claims should be discouraged. The Omnibus Objection also notes that the Debtors are still reviewing almost 20,000 proofs of claim, including over 2,000 proofs of claim asserting 503(b)(9) priority, and therefore the Vendors’ motions are premature: until a chapter 11 plan is consummated, creditors are not entitled to payment for claims entitled to 503(b)(9) priority.

A hearing is scheduled for May 21, 2019. We will continue to monitor this evolving story.

[1] Final Order Authorizing Debtors to (I) Pay Prepetition Claims of (A) Shippers, Warehousemen, and Other Non-Merchandise Lien Claimants and (B) Holders Of PACA/PASA Claims, and (II) Confirm Administrative Expense Priority for Prepetition Orders Delivered to the Debtors Postpetition, and Satisfy Such Obligations in the Ordinary Course of Business [Dkt. 843].

[2] A claim is entitled to administrative expense priority if “it arises out of a transaction between the creditor and the bankrupt’s trustee or debtor in possession and only to the extent that the consideration supporting the claimant’s right to payment was both supplied to and beneficial to the debtor-in-possession in the operation of its business.” In re Bethlehem Steel Corp., 479 F.3d 167, 172 (2d Cir. 2007), citing Trustees of Amalgamated Ins. Fund v. McFarlin’s, 789 F.2d 98, 101 (2d Cir. 1986).

[3] In re World Imports Ltd., 862 F.3d 338 (3d Cir. 2017) (“World Imports”). See also In re SRC Liquidation LLC, 573 B.R. 537 (Bankr. D. Del. 2017). For additional insights and background, please see the author’s Legal Development Alert published August 3, 2017, 3rd Circuit and Delaware Bankruptcy Court Hold that “Receipt” Under Bankruptcy Code Section 503(b)(9) Requires Physical Possession.

Douglas Schneller handles a broad range of complex transactional matters involving bank finance and lending; restructuring, bankruptcy and insolvency; inter-creditor and subordination arrangements, including for mezzanine, leveraged, multi-lien and unitranche financings; claims analysis and reconciliation; and purchases and sales of par and distressed assets such as bank loans, notes, accounts receivable, trade claims, bankruptcy claims, and equity interests. Read more about Douglas.