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Is the Sky Falling?
Not If You Are a Critical Vendor
It is a fortunate business that hasn't experienced the anguish and
uncertainty of one of its key customers filing for bankruptcy protection.
A common reaction of financial officers of companies doing business with
the debtor is to immediately assume that they will never get paid any of
the pre-petition (before the date of the filing of the bankruptcy) amounts
they are owed. This assumption is often premature, because many vendors
who are knowledgeable about bankruptcy matters and who react quickly to
the bankruptcy of one of their customers may be able to greatly enhance
their recovery and their ability to continue a profitable business
relationship with the reorganized debtor. Over the last ten years or so,
many creditors have taken advantage of the "critical vendor doctrine" to
get paid some or all of their pre-petition debt. Recent developments have
restricted the doctrine, but it is still a valuable tool which may result
in payment of your pre-petition debt on an accelerated basis.
Background
One of the most fundamental principles of bankruptcy law is that the
debtor is prohibited from paying pre-petition unsecured claims unless
pursuant to a confirmed plan of reorganization or other court order. The
goal of a Chapter 11 bankruptcy proceeding is to permit the debtor to
reorganize as long as the debtor can propose a plan of reorganization that
is fair and equitable to each class of creditors. Allowing the debtor to
pay certain pre-petition unsecured creditors to the exclusion of others is
not consistent with that goal. Despite this fundamental concept,
bankruptcy courts have permitted exceptions pursuant to the "critical
vendor doctrine" which, in certain limited circumstances, allows debtors
to pay pre-petition obligations to vendors whose continuing supply of
goods or services were deemed necessary for the survival of the debtor.
What Is a Critical Vendor Program?
Where a debtor proposes to pay a group of its critical vendors in
exchange for continuing to ship goods post-petition (after the date of the
filing of the bankruptcy proceeding), courts and attorneys call the
debtor's proposal a critical vendor program. Initially, courts limited the
payment of pre-petition claims to only those vendors whose goods were
essential or unique to the business of the debtor and, without which, the
debtor's business would be crippled and unable to continue, thereby
jeopardizing the debtor's reorganization efforts. Payment of pre-petition
claims was rare and limited to extreme circumstances. Over the last decade
or so, however, the application of the doctrine has been greatly expanded
to cover a larger group of creditors, and the standard utilized to justify
critical vendor payments has been relaxed. As a result, unsecured trade
creditors in most medium to large sized bankruptcies are taking the
position with debtors that they will not continue to supply goods unless
they are afforded critical vendor treatment.
Critical vendor programs usually involve the payment of some or all of
a trade creditor's pre-petition claim in exchange for the creditor
agreeing to continue to supply goods or services post-petition upon
favorable trade terms. In addition, some critical vendor programs provide
that creditors who are deemed to be critical vendors and who continue to
deliver goods post-petition will also receive a lien against assets of the
debtor to secure payment for goods and/or services delivered
post-petition. The debtors generally are the sole determiners of which
creditors will receive critical vendor payments, and they are often not
required to disclose, in advance of payment, which creditors were
considered to be critical. The process is very much a process of
negotiation between the debtor and individual creditors. Since the
critical vendor program contemplates the payment of pre-petition claims,
court approval is required; however, courts have routinely approved such
payments in commercial bankruptcies.
Obviously, if there exists a way for creditors to get their
pre-petition debt paid without having to wait a significant period of time
for a plan of reorganization (which may never be proposed or, if proposed,
it may not be approved), then one can only imagine how popular such
programs are and how important it is to a particular creditor to be
designated a critical vendor. For attorneys representing unsecured trade
creditors, the key is to move quickly to negotiate with the debtor
regarding critical vendor status in exchange for the resumption or
continuation of delivery of goods on credit. Before you get too excited,
however, it is important to recognize that if the debtor can buy similar
goods as those you provide at similar prices from other suppliers without
having to pay pre-petition debt, then the debtor more likely will go with
the new supplier and not give you preferred treatment. By way of further
warning, if your company has a contractual obligation to supply goods to
the debtor, refusing to deliver goods post-petition until you are paid on
the pre-petition debt is tantamount to a violation of the automatic stay
and can subject your company to sanctions.
Is a Blue Light a Red Light for Critical Vendor Programs?
Unfortunately, it is not all good news with respect to critical vendor
programs. A recent decision by the Seventh Circuit Court of Appeals
arising out of the Kmart bankruptcy has called into question the viability
of the "critical vendor doctrine." As part of Kmart's motions filed on the
first day of its bankruptcy proceeding, it sought permission from the
court to implement a critical vendor program and to pay any claim of
creditors that Kmart determined to be critical as long as such creditor
agreed to continue to supply goods for a two year period on customary
trade terms. Pursuant to the critical vendor program, Kmart paid
approximately $300 million in pre-petition debt to approximately 2,330
vendors. One of the approximately 2,000 remaining vendors appealed the
entry of the order. In Capital Factors, Inc. v. Kmart Corp., 291 B.R.
818 (N.D. Ill. 2003) the district court for the Northern District of
Illinois reversed the bankruptcy court's order finding that there was no
statutory basis for the "critical vendor doctrine" and that it was
contrary to the Bankruptcy Code's fundamental scheme of priorities. On
appeal, the Seventh Circuit appellate court agreed with the district
court. As a result, the critical vendors in the Kmart program are being
sued for return of the critical vendor payments they received. The Seventh
Circuit's appellate decision does not completely shut the door on the
"critical vendor doctrine," but it severely restricts its application.
The Seventh Circuit is not alone in restricting the application of the
doctrine of necessity. The Bankruptcy Court for the Northern District of
Texas in In re CoServ, L.L.C., 273 B.R. 487 (N.D. TX 2002) has
established a three element test when determining whether to approve a
critical vendor program: 1) the proposed critical vendor is indispensable
to the debtor—in other words—the debtor must deal with this creditor;
2) the failure to deal with the creditor will cause harm to the debtor
in a disproportionate amount to the amount of the claim; and 3) there is no
practical or legal alternative to payment of the claim.
Happy Endings
In light of the recent trend in decisions limiting the application of
the critical vendor doctrine, it appears that courts following this trend
are taking a more active role in determining which creditors are entitled
to critical vendor status; however, the news is not all bad for unsecured
trade creditors. The Seventh Circuit did not kill the critical vendor
doctrine; it just limited the doctrine. Further, not all jurisdictions
have adopted the recent restrictive approach; therefore, in those
jurisdictions, the trade creditors may still be in a position to
successfully negotiate favorable treatment at the outset of a bankruptcy
proceeding without the debtor having to meet the more restrictive
standards set forth in the recent cases discussed herein. Debtors wanting
to establish critical vendor programs should be prepared to provide notice
of the details of the proposal to non-critical vendors and must be able to
establish to the court 1) the need to pay critical vendors, 2) the lack of
harm to non-critical vendors, and 3) how the estate benefits as a result
of the proposed payments. The bottom line is that, even if the debtor
files its bankruptcy proceeding in a jurisdiction which has adopted the
more restrictive standard, the "critical vendor doctrine" is still
available to those creditors who supply goods essential to the debtor's
business when such goods can't be obtained by the debtor on credit terms
elsewhere.
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