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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

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