Critical Vendors and KMart
Is the Critical Vendor Doctrine Alive?
By Scott E. Blakeley
Credit professionals whose companies have key supplier
relationships may find themselves with sizeable unsecured claims
should that customer file Chapter 11. However, a number of bankruptcy
courts have embraced the critical or essential vendor doctrine. 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 pre-bankruptcy claims paid in
exchange for postpetition trade credit.
Kmart's Chapter 11 was one of the largest filings by
a retailer. In an effort to obtain unsecured credit from its vendors
and maintain key vendor relationships, Kmart, in the opening days
of the bankruptcy, rewarded certain key domestic and foreign vendors
with payment on their pre-bankruptcy claims under the critical vendor
doctrine. Vendors supplying a range of products from food to music
to publishing services were paid on their prepetition claims in exchange
for these vendors providing postpetition trade credit. The bankruptcy
court authorized payments to the critical vendors totaling $327 million
under the "doctrine of necessity" using its equitable powers of section
105 of the Bankruptcy Code. Capital Factors (CF), a company that
had factored accounts and held an unsecured claim, objected.
CF appealed the bankruptcy court's ruling authorizing
payment to vendors under the critical vendor doctrine. The District
Court recently reversed the bankruptcy court.
The main issue on appeal was whether the "doctrine
of necessity" provides the bankruptcy court with statutory or equitable
authority to allow payment of prepetition unsecured trade claims
prior to confirmation of a Chapter 11 plan. The second issue was
whether there was a sufficient evidentiary basis for the Bankruptcy
Court's ruling.
Under section 105, the "doctrine of necessity", a bankruptcy
court's power has evolved to justify the pre-plan payment of prepetition
claims of vendors who threaten to withhold goods or services which
are critical to the debtor's continued viability and reorganization.
This doctrine relies only upon a bankruptcy court's equitable powers.
The district court agreed with CF that pursuant to
the Bankruptcy Code, a court cannot ignore the statutory scheme of
priority and express treatment of unsecured claims as provided in
the Bankruptcy Code in favor of "equity." Although the payments to
vendors are useful and practical, they are not authorized by the
Bankruptcy Code the district court stated. Congress has not elected
to codify the doctrine of necessity or otherwise permit pre-plan
payment of prepetition unsecured claims, the court observed. The
district court found that the bankruptcy court did not have either
the statutory or equitable power to provide such relief.
Kmart argued that CF's request was moot because the
critical vendor payments had been made, and that the vendors who
received the payments relied upon such payments extended postpetition
credit. The district court ruled that it is not too late to order
that the monies paid be returned, because there has not been a confirmation
of a bankruptcy plan.
Thus, the district court reversed the bankruptcy court's
order authorizing payment of prepetition claims to certain critical
vendors. The district court's ruling is being appealed to the 7th
Circuit Court of Appeals. Even so, one of the biggest obstacles to
the court's approval of the reorganization plan was removed when
CF reached a deal with Kmart. Kmart will pay back some of the debt,
and ESL (Kmart's largest shareholder) will buy an unspecified part
of the debt. Kmart agreed to try to get back some payments to so-called "critical
vendors" it made at the outset of its bankruptcy case. CF will get
15% of the money Kmart recovers from the "critical vendors," up to
$2 million.
The district court's ruling out of the Northern District
of Illinois does not bind bankruptcy courts in jurisdictions such
as Delaware, New York and Los Angeles, for example. Thus a debtor
may request the bankruptcy court approve critical vendor payments.
For the vendor, be mindful that should a party appeal a bankruptcy
court's authorization to make critical vendor payments, those payments
may be subject to disgorgement. The district court's ruling may be
significant for courts bound by the decision, as even if a debtor
may establish that its business will be jeopardized if a vendor that
is critical will not ship if not immediately paid under the critical
vendor doctrine, a bankruptcy court may not grant such request. Vendors
will keenly watch whether bankruptcy courts around the country follow
or reject the district court's reasoning in Kmart. At a minimum,
expect the debtor to be more demanding of vendors in establishing
the critical nature of the product or service given the heightened
court scrutiny of these requests.
Corporate Credit Executive
Reprinted by permission from
Trade Vendor Quarterly, Summer 03 |