It’s Alive! Critical Vendor Payments Survive Attacks
by: David Conaway
Shumaker, Loop & Kendrick, LLP; Charlotte, N.C.
In recent years, trade creditors have been able to escape the dismal outcome of most chapter 11 cases by pursuing “critical vendor” payments. Rather than get stuck with unpaid pre-petition debt, the debtor pays the vendor’s claim after the bankruptcy filing. Of course, this violates one of bankruptcy’s most sacred principles – freezing payments of pre-petition debts to provide the debtor with breathing room to rehabilitate itself. In some cases, debtors have also been willing to waive potential preference claims against critical vendors.
After the K-Mart decision, where an appeals court overturned the Chicago bankruptcy court’s approval of excessive and unsupported critical-vendor payments, many predicted the jig was up for vendors. However, in most major U.S. bankruptcy filings since K-Mart, there has been approval of critical-vendor payments, some of which have been liberal, and some quite restrictive (adding to the belief that critical-vendor payments were on the wane). The use of critical-vendor payments has not been “overturned” or eliminated. Courts continue to approve critical-vendor payments where a debtor is able to present a well-reasoned need for such payments.
The real legacy of K-Mart appears to be that debtors, lenders and courts can now point to K-Mart as precedent to severely limit or eliminate critical-vendor payments. Bolstered by the K-Mart decision, debtors and lenders motivated by conserving cash can seek to limit critical-vendor payments. Absent opposition from a significant creditor interest, courts will usually defer to the debtor’s management’s business judgment on the need to make critical vendor payments. In Collins & Aikman, for example, facing severe liquidity issues, and no doubt constrained by its lenders, the debtor sought essentially no critical-vendor authority. In Delphi, critical-vendor payments were limited to those vendors who were on the verge of insolvency themselves. With the number of near-insolvent players in the automotive industry supply chain, the Delphi critical-vendor payments were necessary to keep the supply chain in tact, and thus allow a reorganization to occur. For a major chapter 11 case, however, the payments approved in Delphi were relatively modest.
By contrast, in the Dana Corp. bankruptcy case filed in the Southern District of New York on March 3, 2006, the bankruptcy court approved approximately $52 million of critical-vendor payments. Dana reasoned that its fiduciary obligation was to preserve and maximize its going-concern value, a primary component of which is key business relationships to enable it to provide seamless customer service. The Dana critical-vendor approvals are proof positive that the critical-vendor theory is alive and well, and courts will approve it in appropriate cases.
Even though the critical-vendor remedy may be less prevalent, vendors should continue to pursue the remedy. In fact, given the normal chapter 11 dividend to general unsecured creditors, it is a no-brainer. As always, creditors must in fact be critical, such that failure to supply could seriously disrupt the debtor’s business operation. Moreover, getting paid as a critical vendor usually requires negotiation, and sometimes brinksmanship, with the debtor. Management must be prepared to stop shipments and/or provide credit terms. A debtor has no incentive to use its cash resources for any vendor who continues to ship and provide credit terms unabated. Vendor management may need to evaluate the value of receiving payment on pre-petition debt compared to the value of ongoing business with the debtor.
Although the recent amendment to §503(b) of the Bankruptcy Code now provides trade creditors with an administrative priority claim for "the value of any goods received by the debtor within 20 days before the date of the commencement of a case...in which the goods have been sold to the debtor in the ordinary course of such debtor's business," critical trade creditor status is by no means obsolete. While representing a vast improvement for trade creditor treatment, the improved claim status only extends to 20 days pre-petition. Also, the statutory language is somewhat vague in its reference to the "value" of goods, as opposed to the "price" of the goods shipped. Finally, an administrative priority claim is of no benefit if the case is administratively insolvent.
There are limits to the vendors’ leverage of withholding shipments. Withholding shipments solely to extract payment of a pre-petition debt could be a violation of the Bankruptcy Code’s automatic stay, which “stays” creditors’ efforts to collect pre-petition debts. Also, a pre-petition contract with the debtor may obligate the vendor to continue shipping. Under the Bankruptcy Code, an “executory contract” is any contract where both parties owe each other performance. An executory contract certainly includes a formal supply or requirements contract, but also includes purchase orders that cover prospective sales. The Code grants a chapter 11 debtor the discretion to “assume” or “reject” an executory contract. The theory of giving a debtor this right is to provide the reorganizing debtor the ability to pick and choose which contracts are favorable and which are burdensome. For example, the right to reject collective bargaining agreements is at the core of auto industry’s attempt to rid itself of “legacy debt.”
If the debtor rejects a contract, the rejected vendor is relegated to a holder of a general unsecured claim against the debtor for any unpaid invoices. However, if the debtor assumes the contract, the debtor must “cure” existing defaults, or pay the unpaid pre-petition invoices.
The rub is that the Code requires vendors to perform under contracts while the debtor is deciding to assume or reject. Generally, the debtor is given until plan confirmation to make this election. As a result of this performance requirement, there is risk for a vendor to withhold shipments when the parties have had an ongoing pre-petition contract. Our experience indicates that the obligation to perform does not include an obligation to extend credit. We have found that if a vendor is in fact critical, debtors nevertheless can be persuaded to assume executory contracts.
Perhaps in light of heightened scrutiny by courts after K-Mart, debtors have become more demanding of vendor concessions in exchange for payment of pre-petition debt. Inherent in the debtor’s decision to pay a vendor, either as a critical vendor or pursuant to a contract assumption, is some benefit to the debtor. Perhaps the debtor desires a secure relationship with a vendor, or maybe the debtor desires to lock in pricing or credit terms. It is not realistic to expect a debtor to “cure,” or make critical-vendor payments, unless it believes the benefits received in return will equal or exceed the payment amount.
Moreover, debtors often seek to make the vendor payments over the term of the bankruptcy case without interest. In essence, the vendor discounts its pre-petition claim. This is of lesser concern because payments made to creditors during a chapter 11 case are normally granted administrative priority status. In successful chapter 11 cases, defined as cases where a chapter 11 plan is confirmed, administrative claims must be paid in full. Thus, the risk of nonpayment is relatively low.
Not every chapter 11 case will provide the opportunity for vendors to get paid on their pre-petition debts, but the remedies are there and will work in appropriate cases. Despite the increased judicial scrutiny of critical-vendor payments, vendors should continue to aggressively pursue these and other strategies for payment of pre-petition debt, as they provide the best opportunity for avoiding loss.