Critical Vendor Status in a Business Reorganization

Critical Vendor Status in a Business Reorganization

Often a company that is involved in a formal restructuring (such as Chapter 11) has incurred pre-petition trade debt with various vendors and suppliers.   Many of these vendors and suppliers are critical to the business (or at least more critical than others).    For example, consider the importance of a raw materials (mill work) supplier to a company that makes architectural cabinets or windows.    If the influx of raw materials ceases, the company has no chance of successfully effecting a reorganization or turnaround.     Further, the "importance" of a vendor indicates a high volume of business, and, thus, a sizable pre-petition (unsecured) claim in most cases.   Ordinarily, this claim would be treated as general unsecured debt and no payments could be made to this class of creditors on pre-petition claims outside of a court-confirmed bankruptcy plan of reorganization.    However, in almost all cases, these critical vendors are not contractually obligated to continue doing business with a reorganizing debtor and, in fact, are not going to do so knowing that their unsecured pre-petition claim is going to get largely washed out in the plan for less than face (and, in many case, pennies on the dollar).    Moreover, it may be impracticable for a variety of reasons (pricing, geography, etc...) to find a replacement vendor or supplier.   Even if it were possible, the replacement vendor is going to be very hesitant to commence a new business relationship with a bankrupt entity and, if they did, they would require extremely onerous terms (cash up front, letters of credit, etc...).

For these reasons, the doctrine of necessity otherwise known as the "critical vendor doctrine" (originally codified for railroad cases only) began to creep its way into the more general bankruptcy lexicon.   Even though there was really no express authority for this doctrine under the Code (apart from 1171(b) - specific to railway cases), courts justified orders granting this relief under the exercise of their broad equitable powers under Section 105(a) of the Bankruptcy Code (which provides that a court may "issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of the bankruptcy code").   In fact, requests for this type of relief became almost commonplace among the various "first day motions" that are typically filed at the onset of a Chapter 11 case.

Despite some of the obvious practical benefits in helping to avoid substantial disruption to a reorganizing business (which would seem at some level to help preserve the value of the estate), most federal appellate courts considering the issue have been very chilly towards the doctrine, insofar as it departs the statutory priority and distribution scheme established in Chapter 11 of the Bankruptcy Code.     In fact, it is well known at this point that the United States Court of Appeals for the Seventh Circuit dealt a massive blow to the doctrine in the Matter of KMART Corp.,  359 F.3d 866 (7th Cir 2004) [enhanced version available to lexis.com subscribers / unenhanced version available from lexisONE Free Case Law], where the court invalided nearly $300,000,000 in critical vendor payments made at the inception of the case.

As in the KMART case, the trustee, the unsecured creditors committee and other lenders often argue that this doctrine is contrary to the core bankruptcy principal of ratable and equitable distribution among like-situated creditors, because it (perhaps unfairly) prefers a handful of "critical creditors" over the un-chosen and less important who are forced to wait until the end of the case to resolve their unsecured claim.

The KMART decision did not rule out the possibility that this practice might be sanctioned under Section 363(b) as a court-authorized use of property outside of the ordinary course of business and, in fact, this has become one of the alternative bases in many circuits to request critical vendor relief.   Courts in other circuits have chosen to treat this relief as an exception to the automatic stay under Section 362(a)(6) of the Code.   See, In re: CEI Roofing, Inc., 315 B.R. 50, 59 (Bankr. N.D. Tex. 2004) [enhanced version only]

In short, the doctrine is still viable, but is important for both sides to understand that it is coming under increased scrutiny with a more demanding burden of proof.    Also, whether right or wrong, courts are beginning to look at the financial strength of the vendor in question.    If that vendor will be unable to provide unique goods to the debtors business because of its own financial struggles if not is not afforded critical vendor status, the court will probably be more inclined to grant the relief. 

Visit Distressed Deal: Options and Opportunities for more useful insights, information and analysis - from both a legal and nonlegal standpoint - on issues related to distressed investing, workouts, restructuring, insolvency, and even bankruptcy.  

R. Patrick McCraney
Willoughby Law Group, PLLC
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