Creditors’ Possibility of Recovering Goods from Bankrupt Debtors...

Separation Action Under Mexican Insolvency Law

Mexico’s insolvency law, “Ley de Concursos Mercantiles” (LCM), provides for a “separation action” that gives the right to legitimate owners of goods in possession of debtors who file for bankruptcy to recover them, as long as such goods are identifiable and their ownership has not been transferred by a definitive and irrevocable legal title. This includes goods acquired by the bankrupt on credit and other assets in their possession as a result of a lease agreement, deposit, usufruct or similar. [1] Articles 70 and 71 of LCM set forth a specific and detailed list of cases in which this action proceeds and the requirements to be met for its applicability.

Despite the fact that articles 70 and 71 of the LCM provide a catalog of cases in which the separation action applies, as well as the requirements to be fulfilled, some Mexican federal courts have developed judicial precedents changing the meaning of such an action, as well as its usefulness. They have construed the theory of the separation action as being limited by Article 1 of Mexico’s Business Reorganizations Law, which sets out the “spirit” of said statute: that it is in the public interest to preserve companies that file for bankruptcy, and it avoids that generalized noncompliance with payment obligations may put at risk the viability of such companies and of the others with which they maintain a business relationship. These courts, in conjunction with the official conciliators appointed by the IFECOM (Official Government Institute for Insolvencies in Mexico), have considered that in order to guaranty an adequate protection to companies filing for bankruptcy and their assets, as well as achieve the main goals of conservation and reorganization of said companies, they are obliged to follow certain rules and principles in favor of the bankrupt and, consequently, to the detriment of the creditors who could have access to the separation action. [2]

This has led bankruptcy courts, in practice, to deem separation actions as inapplicable in almost all cases, after considering that the goods and assets subject to separation are essential for the continued operation of the bankrupt; therefore, taking them away from the company would prevent its reorganization — which is precisely the main goal of Mexico’s Business Reorganizations Law. As can be seen, Article 1 has prevailed over Articles 70 and 71 of the LCM, a situation that does not find support in the law or in mandatory jurisprudence.

Therefore, the separation action has been repealed de facto and creditors are left in a doubly disadvantageous position, since not only do they have to bear the burden of the debt owed by the bankrupt — which very likely the creditor will not be able to fully recover, as a general unsecured claim, resulting in distributions of pennies on the dollar or nothing — but on top of that, they are prevented from recovering goods and assets that could be commercially exploited with third parties to make up for their current losses of profit.

While some creditors who fulfill the requirements of the separation action would be able to separate their assets from the bankruptcy estate, some Mexican federal courts have considered that the possession of the assets in the possession of the creditor are necessary for the operation of the company as administrative expenses [3] pursuant to Article 224 of the LCM. With this, the separation action is inhibited, and the right, for example, that a lessor would have to separate his assets from the bankruptcy estate to place it in a new lease is de facto repealed.

Usually, a creditor’s main interest is to recover their goods and assets in order to create a profit from them with third parties other than the bankrupt. This has proven to be impossible in most cases due to Mexican courts’ restrictive interpretation of the separation action.

Reclamation Rights Under the U.S. Bankruptcy Code, General Rules

U.S. bankruptcy law gives a different treatment to the type of cases described above. As a general rule, under section 2-702 of the Uniform Commercial Code, in cases where the seller discovers that the buyer has received goods on credit while insolvent, the seller may reclaim those goods upon demand made within 10 days after their receipt, as long as the goods are in the buyer’s possession at the time reclamation is sought, and they are identifiable.

Additionally, § 546(c) of the Bankruptcy Code sets forth the right of a seller that has sold goods to the debtor in the ordinary course of its business to reclaim such goods if the debtor has received the goods while insolvent, within 45 days before the date of the commencement of the relevant bankruptcy proceeding, as long as the seller demands in writing the reclamation of such goods:

  • no later than 45 days after the date of receipt of those goods by the debtor; or
  • no later than 20 days after the date of the commencement of the case if the 45-day period expires after the commencement of the bankruptcy case.

As in Mexico, § 503(b)(9) of the Bankruptcy Code provides that after notice and a hearing, payment of administrative expenses shall be allowed, including the value of any goods received by the debtor within 20 days before the date of the commencement of a case under chapter 11 in which the goods have been sold to the debtor in the ordinary course of the debtor’s business. These are considered administrative expense claims under § 503(b)(9) of the Bankruptcy Code, which are therefore given priority treatment over general unsecured claims. Hence, they must be paid in full for a chapter 11 debtor to emerge from bankruptcy. Thus, § 503(b)(9) claims are generally paid faster.

Given that it is an administrative expense and not a pre-petition claim, a chapter 11 debtor with the necessary funds can cover the allowed administrative expense before confirmation of a plan. Accordingly, creditors that successfully assert a § 503(b)(9) claim for goods delivered within 20 days of the petition date have an increased likelihood for a full and quicker recovery. [4]

Proposal to Unify Judicial Criteria

Taking into consideration the foregoing, this article does not intend to make an exhaustive study of the separation action (ruled by the LCM) nor the possibility of recovering creditors’ assets in insolvency proceedings under U.S. law. Rather, it intends to explain judicial practices by some Mexican federal courts, and provide elements to overcome their shortcomings, by taking advantage of existing U.S. law and judicial precedents in cross-border litigation proceedings.

The authors of this article consider that Mexican federal courts should standardize their criteria and make a true evaluation of the ratio legis of the separation action as it was conceived in the LCM. Using the U.S. legislation as a reference, creditors should be allowed to reclaim goods and assets from a debtor-applicant for bankruptcy proceedings upon written demand, as long as the goods or assets were received by debtor within a specific time frame before the date of the commencement of the bankruptcy proceeding. This would leave creditors in a better position than where they currently stand, since they would have two options: (1) recover the goods and assets transferred to the bankrupt, which would enable creditors to obtain a profit from them by third parties; or (2) allow the debtor (bankrupt) to continue with the possession of such goods or assets, but give the creditor a priority claim over them — that is, get paid for their use as an administrative expense, prior to any other credit.

[1] Articles 70 and 71 of LCM.

[2] On March 4, 2022, by General Agreement of the Federal Judiciary Council 4/2022, published in the Official Gazette of the Federation, such collegiate body ordered the creation of the First and Second District Courts specialized in Commercial Bankruptcy (“bankruptcy courts”).

[3] Credits contracted for the administration of the bankrupt’s estate, as well as those indispensable to maintain the ordinary operation of the company and the necessary liquidity during the insolvency proceedings.

[4] Bernstein, Scott H. & Rich, Robert A., “Claims for Goods Delivered on the Eve of a Bankruptcy Filing: What Every Business Lawyer Needs to Know,” NY Business Law Journal, Winter 2020, Vol. 14, No. 2.