By Eric Chafetz and Lindsay Sklar

Eric Chafetz and Lindsay Sklar of Lowenstein Sandler examine the decision in In re Sklar Expl. Co., LLC, a case which dealt with Section 503(b)(9) of Chapter 11 of the U.S. Bankruptcy Code and how it relates to trade creditors that supply both goods and services to financially distressed customers.

Section 503(b)(9) of Chapter 11 of the U.S. Bankruptcy Code provides that trade creditors whose goods are received by a debtor within 20 days before a bankruptcy filing are entitled to administrative expense claims for the value of such goods. Notably, §503(b)(9) does not apply to trade creditors that provide services. The main benefit of having an administrative priority claim is that the claim is higher priority than an unsecured claim and is generally required to be paid in full before unsecured claims are entitled to any recovery.

However, when a trade creditor provides both goods and services to a debtor, courts differ on how to treat such a creditor’s claim. Is the entire claim afforded §503(b)(9) treatment? Should courts bifurcate the claim between goods and services, granting a higher priority treatment to the goods portion? If bifurcation is appropriate, how should courts approach this analysis? Not surprisingly, this analysis, for a variety of reasons, is not always straightforward, resulting in courts relying upon different methodologies and tests to analyze the issue.

Background

The U.S. Bankruptcy Court for the District of Colorado (hereafter referred to as the court) recently addressed this issue in In re Sklar Expl. Co., LLC, a case in which the court was required to rule on an amended application for administrative expenses filed by creditor NexTier Completion Solutions related to its pre-petition provision of “acidizing services” to Sklar Exploration Company, the debtor in the case. While the parties’ relationship was predominately based on NexTier’s provision of these services, NexTier also sold the debtor the chemicals necessary (nitrogen and acid) to perform the “acidizing services,” i.e., the “goods.” NexTier valued the chemicals at $62,693.34 and separately itemized the sale of these goods on relevant invoices.

To determine the priority of NexTier’s claim, the court was asked to decide whether the “predominate purpose” test should apply to the §503(b)(9) claim analysis. This test is oftentimes relied upon in hybrid goods/services situations in non-bankruptcy scenarios to determine if the Uniform Commercial Code applies to a given transaction. Under the predominate purpose test, NexTier’s entire claim would be unsecured, as the provision of goods was “merely incidental” to what, for the most part, was a services arrangement.

The court held that although it was a “close call,” the predominate purpose test should not apply. Instead, the court said that it should analyze the goods and service components of the claim separately, resulting in the goods portion being treated as a higher priority §503(b)(9) claim.

Sections 503(B)(9) Claims

Section 503(b)(9) provides a creditor with an administrative expense claim equal to “the value of any goods received by the debtor within 20 days before the date of commencement of a case under this title in which the goods have been sold to the debtor in the ordinary course of such debtor’s business.” (Emphasis added). When analyzing this provision, courts have generally broken the statute down into three discrete parts, including whether: (i) the creditor sold goods to the debtor, (ii) the debtor received the goods within 20 days before the petition date and (iii) the sale of the goods was in the ordinary course of business. The creditor has the burden of proving each element.

The Parties’ Arguments

1. The Definition of “Goods

NexTier and the debtor agreed that NexTier, satisfied the last two elements of the statute. However, they disagreed whether the first element was satisfied, as the Bankruptcy Code neither assigns a definition to the term goods, nor addresses hybrid goods/services situations. Notwithstanding this silence, most courts, including the court in this case, rely upon the definition of goods included in Article 2 of the UCC, which defines goods as “all things (including specially manufactured goods) which are moveable at the time of identification to the contract for sale other than the money in which the price is to be paid, investment securities (Article 8), and things in action.” Accordingly, NexTier argued that the chemicals sold to the debtor fit squarely into the UCC’s definition of “goods.” While the debtor did not directly refute that contention, it instead asserted that NexTier did not provide any “goods.” Rejecting the debtor’s argument, and relying upon other courts’ prior decisions, the court in this case held that chemicals did fall under the UCC’s definition of goods because they were clearly “movable” and because the goods were separately referenced and valued on NexTier’s invoices, meaning they were identified and quantified.

2. Hybrid Goods/Services Contracts and the “Predominate Purpose Test”

To determine whether the debtor’s relationship with NexTier was primarily a goods or services arrangement, the debtor requested that the court apply the predominate purpose test, which focuses on whether Article 2 the UCC governs a given transaction (as UCC § 2-102 only applies to “transactions in goods” and not to the provision of services), rather than analyzing whether any specific item sold as part of a transaction is a “good.” Under this test, the court is tasked with determining whether goods or services are the dominate aspect of the parties’ hybrid relationship. If the services aspect is dominant, then the entire underlying claim will be treated as unsecured instead of as a higher priority §503(b)(9) claim. In other words, the analysis under this test, when applied in the §503(b)(9) context, results in a zero-sum game. In support of this argument, the debtor relied upon In re Circuit City Stores, Inc., 416 B.R. 531, in which the Bankruptcy Court for the Eastern District of Virginia concluded that §503(b)(9) only applies if the contract between the claimant and the debtor is predominantly for the “sale of goods.” Given that the contract in question was predominantly for a sale of services, the court in that case concluded that the claimant was only entitled to a nonpriority unsecured claim.

In response, the court in the NexTier case distinguished Circuit City’s holding by observing that a majority of courts confronting hybrid contracts in the context of §503(b)(9) claim analysis have held that the UCC’s predominate purpose test should not apply. Relying primarily on In re Plastech Eng’rd Prod., Inc., 397 B.R. 828, 837, the court observed that: (i) the predominate purpose test is “irrelevant” when analyzing §503(b)(9), as the section only requires a determination of the value of the goods, even when services were also provided; (ii) the predominate purpose test does not help the court determine if goods were not sold; and (iii) nothing in §503(b)(9) requires “a winner take all approach” (i.e., a claim for goods or services, but not both).

With respect to Circuit City, the court in the NexTier case found that the Circuit City court had improperly applied the predominant purpose test by “importing the limited scope of the UCC Article 2 into §503(b)(9).” Unlike Article 2 of the UCC, §503(b)(9) does not reference a “transaction in goods,” or even use the word “transaction.” Instead, the proper §503(b)(9) analysis only requires an assessment of whether goods were sold to the debtor. Thus, the court in the NexTier case held that while the “wider-focus,” all-or-nothing predominate purpose test may be appealing to use in this hybrid scenario, the §503(b)(9) analysis requires a more nuanced focus. Indeed, a court can simply bifurcate the costs of goods and the services and then assign priority claim status to any goods provided.

In addition, the court also rejected the debtor’s congressional intent argument, which focused on how the predominate purpose test should apply, because the implementation of §503(b)(9) was presumably intended to replace a creditor’s reclamation rights under §546(c) of the Bankruptcy Code. The court observed that this argument was “dubious at best,” as there was no legislative history addressing §503(b)(9) or the language used in the provision. Specifically, the court noted: (i) the text of §503(b)(9) does not specifically reference §546(c) or reclamation; (ii) the cross-reference in §546(c)(2) to §503(b)(9)1 appears to be an alternative remedy to reclamation, not an enhancement of such rights; and (iii) even if there was a link between the two provisions, there was no “wholesale adoption of UCC reclamation principles by the code” and thus no limitation on §503(b) (9) by the UCC’s reclamation principles, or a concomitant requirement to rely upon the predominant purpose test.

Finally, the court rejected the debtor’s slippery slope argument. The court disagreed that providing NexTier a §503(b)(9) claim would invite too many other vendors that provide both goods and services to assert administrative priority claims where the main purpose of the contract was for the provision of services. Instead, the court found that the intent underlying §503(b)(9) was to allow claimants, like NexTier, to separately identify the value of any goods and services provided during the 20-day period and reap the benefit of a higher priority §503(b)(9) claim for any goods provided.

Conclusion

The reasons for the debtor’s opposition to the application were clear: The debtor was trying to preserve scarce estate resources and limit the scope of priority claims, as courts have almost universally held that the recognition of priority claims should be narrowly construed. However, the court determined that while the UCC’s definition of goods may apply under §503(b)(9), that does not mean the predominant purpose test must also apply. Instead, the court, like most of its predecessors, adopted a more Solomonic approach that, in its view, was more in line with the text of §503(b)(9). This analytical framework focused on the goods and services aspects of the claim separately and granted a higher priority §503(b)(9) claim to the goods provided.

Although the court’s task of bifurcating the goods and services was relatively easy, as NexTier’s invoices distinguished between the value of the goods and the value of the services, it is not hard to envision a situation in which the delineation would not be as straightforward. Accordingly, trade creditors that supply both goods and services to a financially distressed customer should clearly separate the value and cost of the goods and services in their invoices and other transaction documents so they can maximize the chances of being granted a higher priority §503(b)(9) claim in the event of a customer’s bankruptcy.