United States: All Aboard! Navigating The Choppy Waters Of The Critical Vendor Doctrine

Last Updated: October 1 2019
Article by Paul Hammer

A fundamental rule in bankruptcy proceedings is that prepetition claims are not paid without a plan or separate order of the bankruptcy court.  Orders allowing payment of prepetition claims prior to the payments approved by a bankruptcy plan are very rare. One of these rare possibilities is the request to deem a creditor "critical".  Because this practice goes against the fundamental essence of bankruptcy law, movants must be prepared to meet specific criteria to prevail. This article dives into this nuanced area and provides guidance to increase the chances of success.

Basis For Critical Vendor Treatment

Many courts rely on Section 105(a) of the Bankruptcy Code as the legal basis for allowing critical vendor payments. Section 105(a) grants bankruptcy courts broad statutory authority to enforce the Bankruptcy Code based on equitable common law doctrines. One such doctrine, "the doctrine of necessity", argues that the critical payments allow for reorganization and a greater recovery to the remaining creditors than they could expect without such critical payments. That is, without critical vendor payments, key business relationships will fail, i.e., the vendor will no longer do business with the debtor unless it is allowed to be paid in a priority manner, leading to an undue obstacle to a successful reorganization and the resulting harm to the debtor and all of its interested parties.  Many courts, including, as will be shown below, those in Texas, allow some form of prepetition critical vendor payments, provided certain requirements are met.

Texas's Three-Part Test

Texas bankruptcy courts have established a three part test, one which is still regularly cited to and applied in modern practice, to determine whether a vendor is "critical". See In re CEI Roofing, Inc., 315 B.R. 50 (Bankr.N.D.Tex.2004); In re Tusa–Expo Holdings, Inc., 2008 WL 4857954 *2 (Bankr.N.D.Tex.2008).  These courts concluded that Section 105(a) alone could not justify application of the doctrine of necessity.  They set forth the following three conditions for evaluating critical vendor treatment.  These criteria represent a practical way analyze and ultimately prove whether a payment is "critical":

  1. the debtor must have a critical need to deal with the specific creditor;
  2. unless the debtor deals with the creditor, the debtor risks (i) the probability of harm, or, alternatively, (ii) loss of some economic benefit to the estate's going concern value, that is disproportionate to the payment; and
  3. there is no other practical or legal solution other than payment of the claim.

Attaining Critical Vendor Status – Practice Tips for Creditors  

The burden of establishing whether a creditor is "critical" falls upon the debtor.  From a practical standpoint, the chances of success will increase if the debtor and the purported "critical" vendor join in a united front in presenting the motion and its supporting evidence and testimony.  Because the very nature of these motions provide for preferential treatment to a trade vendor, it is natural to expect resistance from other creditors.  Bottom line is, it must be shown how the commercial relationship is vital to ongoing operations and a successful restructuring (for example, the vendor provides a unique service or good that cannot be easily found or replicated on the market and, without it, the vendor simply won't do business with the debtor and the debtor's business will fail).  It is important to emphasize that courts are fixated on whether or not the purported "critical" vendor would not do any business going forward with the debtor unless it were afforced "critical" status; if the creditor waivers on this issue, in even the slightest way, the motion will almost certainly fail.

Assuming success in being named a "critical vendor", creditors should be on the lookout for the following, and demand their inclusion in the order granting the motion, whenever possible:

  • Ability of the vendor to raise prices during the new, post-petition "critical" vendor relationship;
  • A preference waiver for any payments received by the vendor from the debtor during the 90-day period before bankruptcy;
  • A disgorgement waiver providing that critical vendor payments to the vendor may not be clawed back if the critical vendor order is reversed;
  • A disgorgement waiver providing that critical vendor payments to the vendor may not be clawed back if the case converts to a Chapter 7 liquidation or becomes a liquidating Chapter 11 case;
  • Ability to terminate the new, post-petition "critical" vendor relationship if the debtor defaults on its obligations to the vendor; and
  • Ensuring that the new, post-petition "critical" vendor relationship is categorized as a post-petition agreement, and will be treated as such throughout the bankruptcy.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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