Does the Lenders’ Lien Attach When a Shipper Disregards a Demand to Stop Delivery?

June 15, 2017

What happens if a shipper refuses to honor a seller’s demand to stop delivery of goods in transit? Is the seller out of luck, and does the secured lender keep the proceeds of the goods sold after the buyer “went chapter 11”?

To learn the answer, stay tuned to the chapter 11 liquidation of retailer Sports Authority Holdings Inc. So far, the seller appears to be coming out on top.

The retailer purchased goods on credit from the manufacturer in China. While the goods were in transit, the manufacturer learned that the buyer was on the brink of chapter 11. The manufacturer sent notices to the shipper demanding that it stop delivery under Section 2-705 of Delaware’s Uniform Commercial Code.

Allegedly at the insistence of the retailer, the shipper refused to honor the demand and delivered the goods to the retailer. The goods were sold, and the proceeds went to the secured lenders.

The seller initiated an adversary proceeding against the bankrupt retailer and the secured lenders, seeking a declaration that the goods never became the debtor’s property and that the seller’s rights in the goods and proceeds were superior to the rights of the secured lenders.

Of note, the bankruptcy court had approved a typical financing arrangement with a deadline for contesting the validity of post-petition liens given to the lenders. By the challenge deadline, the seller did not file an objection to the lending arrangement. Nor did the seller file a timely reclamation demand.

The secured lenders filed a motion to dismiss but lost in a March 1 opinion by Bankruptcy Judge Mary F. Walrath.

The lenders argued that the seller was obliged to file a reclamation demand once the shipper refused to honor the stoppage demands. Because the seller waived its reclamation rights, the lenders contended that the seller lost any claims it might have had against them, and particularly so because the seller never mounted a timely challenge to the post-petition financing order.

Judge Walrath cited UCC § 2-705(3)(b) as providing that a shipper must hold the goods after receipt of a stoppage notice and may deliver them only on instructions from the seller. She said that the seller has the right to stop delivery regardless of who has title or the risk of loss.

On the other hand, Judge Walrath cited UCC § 2-702 for the proposition that a seller’s remedy is limited to reclamation once the buyer receives the goods. Furthermore, under UCC § 2-702(3), the seller’s rights are subordinate to the rights of a good faith purchaser, which can include a secured lender. In addition, the seller waives reclamation rights absent a timely demand.

The seller argued to Judge Walrath that it was not obliged to pursue reclamation rights after giving a stoppage demand.

Judge Walrath declined to dismiss the complaint under Rule 12(b)(6) because the seller stated a plausible claim. Unlike reclamation rights, she said that “stoppage rights are not subject to the rights of a good faith purchaser.”

Citing a Delaware bankruptcy court decision from 2002, she also said that the UCC does not permit a sale free of a seller’s right to stop delivery.

Stacking the odds further against the secured lenders, Judge Walrath cited an official comment to the UCC § 2-705 as saying that “the seller’s rights in the goods are the same as if he had never made a delivery,” after giving an effective stoppage notice.

Judge Walrath also brushed aside the lenders’ argument that the adversary proceeding was an untimely objection to the chapter 11 financing order. She said the seller was pursuing a declaration that the goods were not property of the estate and was not challenging the validity of post-petition liens.

At this stage, Judge Walrath has only denied a motion to dismiss. There is no guarantee the result will be the same on a motion for summary judgment. The opinion could be read as a suggestion from the bench that the parties should consider settlement.

The opinion does not deal with claims the seller also has against the debtor or the shipper.

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