Courts Continue To Recognize
Essential Vendor Doctrine
The Judicial Approval of a PreferenceBy 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:
ESSENTIAL TRADE VENDOR
[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]
Reprinted by permission from Trade Vendor Quarterly
Blakeley & Blakeley
LLP Summer 02