Trade creditors or vendors know that a customer’s Chapter 11 filing can mean long delays before receiving any payment on a pre-petition account, and that payment is usually a fraction of the amount owed. Traditionally, a vendor files a proof of claim and presses for a meaningful payment, usually with little success. Do vendors, especially those integral to a debtor’s survival, have any recourse? Fortunately, with the development of the "critical vendor doctrine", creditors may have a meaningful alternative.
The critical vendor doctrine applies to vendors that are so vital to the continued business operations of the debtor that their refusal to sell to the debtor could mean the demise of the debtor and its reorganization. In this situation, the debtor may request the court authorize it to make immediate payment of the vendor’s pre-petition claim, in exchange for a commitment by the vendor to sell to the debtor on a post-petition basis under the same or better terms (the uniqueness of a particular product or service, however, may give the vendor more leverage in negotiating more favorable post-petition sales terms). This arrangement elevates critical vendors’ otherwise low-priority pre-petition unsecured claim to higher priority administrative claim, ensuring payment in full if the debtor successfully reorganizes.
The authority for granting critical vendor status stems from the Bankruptcy Code and has been developed through case law. In approving such critical vendor arrangements, bankruptcy courts have relied on the "necessity of payment" doctrine and the equitable powers that Section 105(a) of the Bankruptcy Code grants to the bankruptcy courts, which allows them to "issue any order, process or judgment that is necessary or appropriate to carry out the provisions of this title."
However, given the lack of a specific statute altering the priority scheme of the Bankruptcy Code, many courts strictly scrutinize a motion to pay critical vendors on pre-petition claims. The critical vendor doctrine can be viewed as conflicting with the fundamental principles underlying the federal Bankruptcy Code—the equitable distribution of the debtor’s assets among similarly situated holders of claims.
These conflicting concerns are highlighted in the Kmart Bankruptcy case pending before the United States Court of Appeals for the Seventh Circuit. Shortly after filing for Chapter 11 in the United States Bankruptcy Court for the Northern District of Illinois, Kmart obtained bankruptcy court approval for payment of the pre-petition obligations to unspecified critical vendors totaling more than $300 million, arguing the company needed to preserve those relationships to facilitate a successful restructuring. The bankruptcy court granted Kmart’s motion over several objections, finding it was "necessary to keep this business going as a going concern." Critical vendors that received payment of their pre-petition claims were required to extend credit to Kmart during the Chapter 11. These vendors did far better than Kmart’s other pre-petition unsecured creditors, which received re-issued stock of de minimus value.
However, a pre-petition unsecured creditor of Kmart that did not receive critical vendor status appealed from the bankruptcy court orders approving the Kmart critical vendors program. The United States District Court for the Northern District of Illinois reversed the bankruptcy court’s decision and held that the bankruptcy court lacked the power to approve the payment of any pre-petition unsecured claim during Kmart’s Chapter 11—no matter how critical the vendor. Although the court acknowledged that the use of the bankruptcy court’s equitable powers under Section 105 may appear practical and beneficial to a debtor’s reorganization, it found that good intentions do not equate to authority under the Code. The court concluded that "the bankruptcy court did not have either the statutory or equitable power to authorize the pre-plan payment of pre-petition unsecured claims," and required critical vendors to return payments received to the estate.
The decision was predicated on a finding that the bankruptcy court order approving preferred treatment for critical vendors unlawfully allowed payment to selected pre-petition unsecured creditors under the necessity of payment doctrine before others were paid, thereby elevating the status of certain general unsecured creditors. The Bankruptcy Code does not codify the necessity of payment doctrine, does not grant critical vendors a priority claim, and does not permit the pre-plan payment of any pre-petition unsecured claims, no matter their importance to the debtor.
Should the Seventh Circuit Court of Appeals uphold the district court’s decision, an appeal to the United States Supreme Court is quite possible. Despite the current uncertainty surrounding the critical vendor doctrine, it remains advisable to position yourself as a critical vendor where possible to elevate your status above those of other creditors.
This article is presented for informational purposes only and is not intended to constitute legal advice.