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Making the Critical Vendor List and the Trade Claims Cap
Critical Vendor Update:
By Scott E. Blakeley

The credit professional well knows that a customer's Chapter 11 means long delays before receiving any payment on the prepet ition account, which payment is usually but a fraction of the claim. Indeed, it is not uncommon for the vendor to receive stock in the reorganized debtor in exchange for its prepettion claim. Traditionally, the vendor would file a proof of claim, perhaps serve on the creditors' committee, and press for a meaningful payment. Does a vendor in this situation, especially one with substantial trade relationship, have any recourse? Fortunately, with the development of the critical vendor doctrine, the credit professional may have a meaningful alternative.

On occasion a vendor may be a key supplier to a customer which files Chapter 11. Given this key supplier relationship, the vendor often holds a sizeable unsecured claim upon the Chapter 11 filing. The vendor, selling invoice by invoice (as opposed to long term supply contract), may elect not to continue to sell the debtor postpetiton. However, the vendor's product or service may be viewed by the debtor as essential to its continued operations.

In this situation the debtor may request that the court authorize it to immediately pay the vendor's prepetition claim, in exchange for the vendor selling to the debtor post-bankruptcy on credit. Under the critical 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 critical and have their pre-bankruptcy claims paid in exchange for postpetition trade credit. As a bankruptcy court noted, "[p]ayment 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." In re Wehrenberg, 260 B.R. 468 (Bankr. MO 2001).

The Critical Vendor Doctrine

To be classed as "critical" by a Chapter 11 customer is usually an extraordinary result for the vendor as it means payment in full or a substantial portion or the prepetition claim, given the alternative of waiting, perhaps for years but for a fraction of the prepetition claim. However, a Chapter 11 debtor's funds available for the critical vendor class is limited, as well as scrutinized (and perhaps objected to) by lenders, bondholders, noteholders, a creditors' committee, the U.S. Trustee's office, and even competing vendors who want to be elevated to critical vendor status.

With some of the largest public companies filing Chapter 11, critical vendor motions are more common - - and more scrutinized than ever. Bankruptcy judges are now often insisting on detailed support to pay a vendor immediately on the prepetition claim. The judges are also granting immediate relief on an interim basis in order to give other parties involved, such as a creditor's committee, time to review the request.

The critical vendor doctrine may be viewed as conflicting with a fundamental principle of bankruptcy which is equal treatment (e.g. payment) for the same class of unsecured creditors' claims. In bankruptcy, the general rule is that vendors may be paid on their unsecured claims only through a confirmed plan of reorganization or court-authorized liquidation.

A number of courts throughout the country have carved an exception to this general rule and labeled it the critical vendor doctrine. Under the doctrine, a debtor may pay certain prepetition claims, with court approval, at the commencement of the bankruptcy case where it can be established that payment of those claims will help to stabilize the debtor's business without significantly harming any party. The payment of these claims is to induce vendors to continue supplying key goods and services post-bankruptcy on credit, which may enable a debtor to continue to operate and perhaps exit bankruptcy. In exchange for the vendor being paid in full, the debtor conditions the vendor extending comparable credit terms postpetition. The critical vendor agreement is reflected in a letter agreement between the debtor and the vendor. The agreement also provides for a "claw back" provision that permits the debtor to recapture the critical vendor payment if the vendor refuses to continue to extend credit.

A number of bankruptcy courts, from United Airlines to Encompass, have recently approved the debtor's request for a critical vendor program, subject to a claims' cap. How does the vendor get on the critical,vendor list? What is a claims cap?

Making the Critical Vendor List

A Chapter 11 debtor that is an operating business must decide which vendors they need most, and then negotiate a payment. The debtor places the "critical" vendors on a list. Those vendors that do not make the list will receive payment through a confirmed plan of reorganization or Chapter 7 liquidation, often years after the filing. The critical vendor motion is filed by the debtor with the bankruptcy court and provides that the vendor will receive payment on the prepetition claim. The motion also binds the vendor to continue to sell with the debtor on terms equal to or better than prepetition terms. The dollar amounts sought are high. WorldCom Inc. was authorized to pay vendors up to $70 million. The average relief granted to a midsized debtor has ranged from $8 million to $25 million. The responsibility to define the vendors typically has been placed in the hands of the debtors. When a company files for bankruptcy, it reviews a list of its vendors and decides which ones are critical in order to stay in business.

Another strategy for a debtor is not identifying their critical vendors in court pleadings, which are public documents, to avoid alienating those vendors who don't make the list. It seems the leverage of the critical vendor request may be shifting from the vendor to the debtor. The vendor may hold out continued sales to the debtor thereby threatening the debtor's ongoing operations, perhaps only to find a replacement vendor who qualifies as a critical vendor.

The Trade Claims Cap

The critical vendor doctrine has evolved from the debtor requesting a particular vendor be paid immediately as a critical vendor, to the debtor requesting a class of vendors qualify as critical vendors, to the debtor requesting the bankruptcy court establish a critical vendor "trade claims cap". For example, in the United Airlines Chapter 11, the carrier requested that the bankruptcy court pay trade claims totaling $35 million as critical. United Airlines did not identify the vendors it would deem critical. Rather, United Airlines requested the court authorize payment of a class of vendors it deemed critical which represented about 14% of vendors unsecured claims. United Airlines did not propose to pay in full each vendor deemed criticritical, but only the minimum for the vendor to continue selling on credit.

The courts application of the critical vendor doctrine continues to evolve. Debtors more frequently request courts' approval of the critical vendor program. Where the doctrine is approved, courts reason, both the debtors and creditors stand to gain something. The critical vendor benefits by receiving early payment on its prep etition 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 -so get on the list!

Corporate Credit Executive
Reprinted by permission from
Trade Vendor Quarterly, Spring 03

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