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Bankruptcy Courts Continue To Recognize
Essential Vendor Doctrine
The Judicial Approval of a Preference
By Scott Blakeley

Vendors are wrestling with bankruptcy trustees and liquidating agents in record numbers over the bankruptcy preference. The bankruptcy preference requires a vendor to give back payments received within the 90 days prior to the bankrkuptcy filing, subject to a vendor's defenses such as the subsequent advance and ordinary course of business.

A twist to the preference laws is the recent trend of bankruptcy courts to authorize a debtor in some instances to pay certain vendors post-bankruptcy on account of their pre-bankruptcy claims, the so-called essential vendor or critical vendor. In other words, if the vendor received payment prior to the bankruptcy on account of a delinquent account the vendor may be subject to a preference for the payment. However, if the vendor is selected as an essential vendor by the debtor and the bankruptcy court authorizes the post-bankruptcy payment on the pre-bankruptcy delinquent account, no preference.

Under the essential vendor doctrine, a vendor may find that the product or service it provides a Chapter 11 debtor is essential to continued operations. The uniqueness of the product or service may give the vendor leverage in negotiating post-bankruptcy sales. More and more bankruptcy courts are considering a debtor's request to treat certain vendors as essential and have their prebankruptcy claims paid in exchange for postpetition trade credit. A number of bankruptcy courts, from Owens Corning to Bethlehem Steel, to the Warnaco Group, Baldwin Piano, AGA Flowers and Federal Mogul, have recently approved the debtor's request for an essential vendor program. Vendors in the Kmart Chapter 11 proceeding witnessed the bankruptcy court approve Kmart's request to pay Fleming Foods, as well as its liquor and music suppliers, among others. Two bankruptcy courts recently published opinions recognizing the essential vendor program.

The bankruptcy court in the Payless Cashways retail stores Chapter 11 considered the debtor's request to treat certain lumber suppliers as essential vendors (In re Payless Cashways, Inc., 268 B.R. 543 (Bankr. W.D. Mo. 2001)).

The essential vendor program provided that in exchange for the debtor's payment of all or part of the vendor's prebankruptcy claims, the following terms: the vendor provides standard industry terms, open up to one year following confirmation of a plan of reorganization; critical trade vendor payments would not exceed $10 million. The court's analysis was whether the debtor was able to obtain inventory of similar quality, whether the product was critical to survive, and whether preferring vendors was a better result than shutting down the business.

The court noted that the debtor could not otherwise obtain trade credit, that the creditors' committee did not oppose the request, and that the essential vendor program provided the debtor the opportunity to restock its shelves. The court rejected the Office of the United States Trustee's argument that should the debtor convert to Chapter 7, the essential vendor would have to return the payment as a preference.

In another recent bankruptcy court decision, In re Wehrenberg, 260 B.R. 468 (Bankr. Mo 2001), the debtor, who operated a chain of move theatres, requested to pay prepetition claims of critical vendors. Certain film companies holding unsecured claims refused to continue to provide films to the debtor unless the claims were paid. The court agreed, noting: "Payment of the prepetition claims of these vendors as set out in the Debtor's motion is necessary to realize the possibility of a successful reorganization. . . the Court may authorize the payment of prepetition claims when such payments are necessary to the continued operations of the Debtor." Wehrenberg, 260 at 468.

The courts application of the necessity doctrine continues to evolve. Debtors more frequently request courts' approval of the necessity program, and courts are more receptive. Where the doctrine is approved, courts reason, both the debtors and creditors stand to gain something. The A necessary@ vendor benefits by receiving early payment on its prepetition claim. The debtor and its vendors benefit by receiving needed product on credit, which may lead to a successful reorganization. A vendor being deemed an essential vendor can have a dramatic impact on the account. The credit professional is not forced to wait what may turn out years for uncertain payment from a reorganizing debtor.

In exchange for the vendor being paid in full, the debtor conditions the vendor extending comparable credit terms postpetition. Below is the type of letter that a debtor often requests its essential vendor to sign:


[Name of Essential Trade Vendor] is in receipt of [relevant debtor's] purchase order or invoice ________ requesting shipment of [describe requested goods by type, quantity and price] (the "Goods") or delivery of services ("Services") which was/ were received by us on ______________, 2002, at those places set forth in the Purchase Order or Invoice. (If the Purchase Order requires multiple delivery dates and/ or locations, we have attached a schedule of such information to this Acknowledgement.) We hereby acknowledge and agree that shipment of the Goods or Services will be in accordance with Customary Trade Terms and the Order Granting Debtors Authority for Payment of Prepetition Trade Claims of Essential Trade Vendors entered by the Court. [Name of Essential Trade Vendor]

Printed Name:

Reprinted by permission from Trade Vendor Quarterly
Blakeley & Blakeley LLP Summer 02

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