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Critical Vendor List and Future Sales
You did not make the critical vendor list or the critical vendor motion is denied;
now what with future sales?

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By Scott E. Blakeley
Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley LLP

The credit professional well knows that a customer�s Chapter 11 means long delays before receiving any payment on the prepetition 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? With the development of the critical vendor doctrine, the vendor deemed critical has had a meaningful alternative.

The critical vendor doctrine permits a debtor to select certain vendors it deems as indispensable for its ongoing operations. In this situation, the debtor will pay the vendor�s prepetition claim in the opening days of the case in exchange for the vendor�s commitment to extend credit postpetition. However, the critical vendor doctrine has come under criticism from some creditors and courts, especially since the Kmart ruling. With the increased criticism comes increased creditor and court scrutiny of a debtor�s critical vendor motion. What are a vendor�s alternatives where a debtor�s critical vendor motion is not approved by the bankruptcy court, or the motion is approved but the debtor does not to select the vendor as critical? Are there still opportunities to have the prepetition claim paid? What of postpetition credit risk?

A. 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. Since the Seventh Circuit Court of Appeals ruled in Kmart of a more exacting standard, 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.

The payment of claims deemed critical 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.

B. Critical Vendor Alternatives

Given the increased scrutiny that a critical vendor motion is now subject to, what alternatives are available to a vendor in considering making a sale to a Chapter 11 debtor.

1. Payment of All Vendors� Claims Through Prepack

If a debtor is contemplating Chapter 11, it may negotiate with its major creditor constituiencies, such as bondholders and noteholders, with hopes to reach agreement as to their treatment under a plan of reorganization. These pre-bankruptcy negotiations may result in a consensus not only as to bondholders and noteholders, but vendors as well. For example, in the Trump Hotels bankruptcy, a prepackaged plan was filed that proposed to pay all vendors prepetition claims in full. The debtor did not wait to pay vendors until the plan of reorganization was confirmed, but obtained court approval to pay all of the vendors claims shortly after the Chapter 11 filing. From the vendors� view, this may be viewed as a �super critical� vendor motion, given that all vendors� prepetition claims were to be paid. As the plan of reorganization had been prearranged, the court approved the early payment of all of the vendors, without the debtor going through the rigors of meeting the critical vendor elements.

2. Selling on Credit Postpetition

To encourage vendors to sell a debtor on credit postpetition, the Bankruptcy Code provides that should the debtor default on the credit sale, the vendor is entitled to an administrative claim for the unpaid balance. Unlike the critical vendor doctrine, a postpetition credit sale does not allow for payment on the prepetition claim. The vendor should be mindful that while the Bankruptcy Code provides for priority status for unpaid postpetition invoices, a vendor holding a priority claim is not guaranteed payment. Rather, a debtor could find itself administratively insolvent. In this situation, the vendor�s priority claim could go unpaid.

a. The Catch Up Issue

If the vendor does not qualify as a critical vendor, the vendor may resolve to find an alternative to have its prepetition claim paid. A general principle of the Bankruptcy Code is that a vendor may not be paid on its prepetition claim postbankruptcy, absent a court order or a confirmed Chapter 11 plan. However, a vendor may attempt to have the debtor pay down its prepetition debt by inflating its postpetition invoices. This �catch up� scheme may beillegal, and can result in disgorgement of the inflated invoices and, possibly, criminal action.

3. Junior Lien Sales

Those vendors that do not qualify as critical, a debtor may offer vendors a junior lien on assets in exchange for selling on credit. The purpose of the junior lien is to reduce the risk that if the debtor fails to pay for the credit sale, the vendor may have some assets to look to for payment. However, the junior lien sale does not pay a vendor�s prepetition claim.

4. Sale of Claim

A vendor that is not selected as critical, may elect to sell its prepetition claim. Third parties, unrelated to the debtor, offer to purchase a trade creditor�s prepetition claim, at a discount. Unlike the critical vendor doctrine, a vendor does not have a continuing obligation to sell the debtor on credit when it sells its claim to a third party. Also, unlike the traditional critical vendor doctrine, a vendor selling their claim does so usually at a steep discount.

C. Consider the Alternatives When Selling to a Chapter 11 Debtor

Those vendor that have been deemed critical are rewarded with immediate payment on their prepetition claim, as well as continued sales (salesperson is happy}. If not deemed critical, the vendor may still have an opportunity to make the sale to a Chapter 11, perhaps even with collateral supporting the sale.

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