When a vendor learns that a customer has sought bankruptcy protection, its first concern is potentially only recovering a small fraction of the indebtedness it is owed. Although that is frequently the outcome for unsecured creditors, under certain circumstances the vendor may be able to recover a substantial portion of its debt by becoming a so-called "critical vendor". This article explains what a critical vendor is and how a vendor/trade creditor can seek to be approved as a critical vendor, which status can often mean the difference between material versus minimal recoveries as an unsecured creditor.

Bankruptcy Code General Prohibition on Payment of Pre-Bankruptcy Unsecured Creditors Prior to Plan Confirmation

The Bankruptcy Code prohibits payments during the pendency of a Chapter 11 bankruptcy case of unsecured claims incurred or due and owing to such vendor prior to the bankruptcy filing until a Chapter 11 plan is confirmed – which can take months or even years (and even once a plan is confirmed, it can take years until any recoveries are realized adequate to provide unsecured creditors any recovery). Furthermore, the Bankruptcy Code has a priority system that ranks general unsecured claims junior to claims for such things as taxes, unpaid wages, claims on account of customer deposits and claims that arise during the bankruptcy case. But there are situations where certain general unsecured creditors can and do get paid ahead of other general unsecured creditors. One of those situations involves what are known as "critical vendors."

What is a "Critical Vendor"?

A critical vendor is a vendor whose product or service is critical to a successful reorganization of the debtor because, without the vendor's product, the reorganization may be hampered or impossible. Critical vendors arise in situations where the vendor is a sole source provider or where replacing the vendor could not be done without great delay.

Critical vendor status is coveted because the vendor can be paid all or a substantial portion of its pre-petition claim. Critical vendor status is typically awarded at the discretion of the debtor, assuming the Bankruptcy Court authorizes the payment of such claims. While a vendor could theoretically file its own motion to obtain critical vendor status, it is highly likely to fail.

Critical vendor treatment derives from the bankruptcy "doctrine of necessity", which allows a Bankruptcy Court to authorize a debtor to pay certain pre-petition claims if it can be shown that payment will help the reorganization process. The debtor pays the critical vendor all or part of its pre-petition claim in exchange for the vendor's agreement to provide essential goods and services to the debtor during bankruptcy. Under a typical critical vendor order, the supplier must agree to continue to do business with the debtor post-petition, typically pursuant to a written agreement (the general form of which is approved by the Bankruptcy Court). A later breach of the critical vendor agreement subsequent to entry by the vendor will typically trigger disgorgement of payments received post-bankruptcy filing on account of pre-bankruptcy claims.

A vendor that is contractually required to continue to sell to the debtor post-petition on credit terms without a critical vendor agreement is less likely to be deemed a critical vendor. The debtor will not see the need to provide such a critical vendor status in order to continue receiving goods on credit from the vendor. On the other hand, refusing to provide credit terms absent critical vendor status presents a difficult decision for the vendor. Refusal to supply on credit may risk loss of the customer and the ability to recoup losses from future sales. Assessing how difficult it would be for the debtor to replace the vendor and how fast it can occur can be difficult.

It is important to be aware pre-petition if the debtor is reducing purchases and shifting them to another vendor. Typically, this occurs where the company cannot get the credit that it needs from one vendor and is able to obtain better credit terms from another vendor. By diversifying its vendor base, the debtor reduces reliance upon a vendor which may otherwise have been deemed as critical.

Criteria for Determining a "Critical Vendor"?

In assessing which vendors may be deemed critical, the debtor may take into account the following:

  • is the vendor in possession of or does it have exclusive access to materials necessary to manufacture the product sold to the debtor?
  • how long would it take for another vendor to source the requisite raw materials?
  • does the vendor have a unique ability to supply the debtor – such as at all rather than some of the debtor's manufacturing facilities?

In addition to requiring Bankruptcy Court authorization to pay critical vendors, a debtor's lender(s) and/or official committee(s) of creditors may object to the treatment of a vendor as critical. A debtor's oral promise at the beginning of the bankruptcy case to treat a vendor as critical is not a guarantee that the vendor actually will receive critical vendor status. Several other parties in interest may object – sometimes at the invitation of the debtor, thereby giving the debtor an excuse to say "I tried but the bank or committee said no." The debtor's goal (and that of the debtor's lenders) is to minimize critical vendor treatment of its suppliers.

Critical vendor court orders are entered early in Chapter 11 cases. A vendor should be proactive and reach out to the debtor immediately after the commencement of the bankruptcy case. If and when a critical vendor order is entered, pay close attention for any discretionary language that may guide the vendor on the debtor's flexibility to deem the vendor as a critical vendor and to negotiate treatment. Creditors should advocate for inclusion in this preferred class of creditors. Then they should negotiate the best deal available — which may not be the one first offered. While a vendor should anticipate that the debtor will assert that it has no flexibility on critical vendor credit terms, in fact a debtor usually does have discretion.

The Bankruptcy Court order authorizing critical vendor treatment may contain (undisclosed or ambiguous) flexibility on required post-petition credit terms to be given by the vendor and also flexibility on the amount of post-petition credit required of the vendor.

Usually, the vendor is told that it must extend the same credit terms post-petition as previously extended in the ordinary course prior to the bankruptcy. "Ordinary course" is an imprecise term. Consequently, the vendor should ensure that the definition of "ordinary course" in any critical vendor order or agreement is clearly explained. Although it often is stated that the vendor must extend credit terms similar to what was extended "in the ordinary course" pre-petition, post-petition credit terms still can be negotiated.

Critical Vendor Language to Negotiate (Where Possible) and Other Options for Vendors to Consider

It may be helpful to negotiate potential critical vendor status earlier in the relationship long before a bankruptcy case is commenced. Below is a draft contract provision that may be incorporated into credit terms.

In exchange for the Vendor extending credit to the Company, the Company shall use its best efforts (including, without limitation, including Vendor in first-day notices and motions) to have Vendor designated as a "critical vendor" entitled to payment in full for all pre-petition deliveries of Products in any bankruptcy proceedings in which any of the Company is the debtor. Vendor shall have no liability or obligation to deliver Products to the Company until the Company has complied in full with all terms and conditions of this section and such designation has been confirmed.

When a company commences a Chapter 11 case, there may be goods that are in transit and scheduled to be delivered to the company soon after the petition date. Step one should be for the vendor (as authorized by the terms of the Uniform Commercial Code) to promptly stop the delivery of the goods in transit until post-petition credit terms have been agreed to. If the debtor has already incorporated the subject goods into its production calendar, stopping the goods in transit can cause an element of urgency to force the debtor to consider granting the vendor critical vendor status.

A company in Chapter 11 can typically exercise business judgment once a critical vendor order is entered by the Bankruptcy Court. And, the vendor can negotiate for an improved deal superior to what it may be initially offered.

Debtors have asked courts for greater flexibility in both the timing and amounts that they can offer in exchange for continued performance by the vendor. For example, payment of less than 100% of the pre-bankruptcy amount owed rather than 100% of the full claim. Receiving less than 100% may be worthwhile for consideration, but the vendor can hold out for 100%. In addition, payment of the pre-bankruptcy amount owed should be required to be made upon execution of the critical vendor agreement even if an initially proposed critical vendor agreement provides otherwise.

Administrative status as a go-forward vendor is also not a guarantee of payment in full. A debtor may become administratively insolvent and may be able only to pay a fraction of administrative claims. A prudent critical vendor should reserve the right to file with the Bankruptcy Court a motion to compel payment of its post-petition administrative claim in the event that the debtor fails to timely pay a post-petition invoice. Section 503(a) of the Bankruptcy Code authorizes such motions. Smart debtors will not want to risk other suppliers seeing a 503(a) motion on the docket because it may cause other vendors to pull back on credit.

It is essential to have triggering events in the critical vendor agreement that authorize the vendor to terminate or modify post-petition credit terms.

Examples of such triggering events include:

  1. filing of a motion to convert the Chapter 11 case to one under Chapter 7;
  2. filing of a plan of reorganization that does not provide for payment in full of the vendor's administrative claim;
  3. filing of a motion to sell assets wherein the purchaser has not agreed to assume the vendor's administrative claim and/or insufficient cash proceeds are left at the debtor's estate to satisfy such claim;
  4. failure to obtain a final order authorizing the debtor's use of cash collateral or authorizing "DIP" financing within 30-45 days of the petition date;
  5. termination of the debtor's authority to use of cash collateral or DIP financing; and
  6. another vendor filing a motion to compel payment of an administrative claim.

A debtor may seek to limit the vendor's ability to seek immediate payment of its administrative claim by limiting the entity or assets from which payment can be sought. This limitation may be to a division, product line, subsidiary, or affiliate of the debtor. Never agree to such a requirement if credit was extended to the company as a whole. Typically, a vendor extends credit to the parent or lead debtor as a whole and not to a division or product line. The vendor may be unaware of the sale value or reorganizability of a specific division or product line. But the debtor probably does. Such a limitation prevents the vendor from seeking later payment (especially where an estate becomes administratively insolvent) from a more lucrative entity. In administratively consolidated cases with a single official committee of creditors, this position of the vendor is even more justified.

Other Claims (Such as Preference Claims) Against Vendors and Other Actions for Vendors to Consider

Obtaining "critical vendor" status in a Chapter 11 case is not a defense to a preference action. The typical critical vendor agreement does not provide protection against litigation to recover allegedly preferential payments. The mere fact that a vendor is authorized to receive critical vendor status is not enough to bar a preference claim. If significant preference exposure exists and the vendor/supplier has leverage, the supplier should seek affirmatively to have the critical vendor agreement with the debtor include preference waiver language.

Upon the commencement of a Chapter 11 case, a "first day" hearing typically occurs before a creditors committee is appointed. Only 24-48 hours' notice of the matters on the court's calendar at the first day hearing will typically be given. A vendor being offered critical vendor status at the outset of a case should obtain written assurances from the debtor's counsel that adequate notice has been provided, especially to secured creditors. It also is important to review notice requirements in local court rules as well as the critical vendor order and to confirm with debtor's counsel that any necessary secured lender consent has been obtained.

Although a post-petition claim of a vendor providing goods or services to a debtor post-Chapter 11 filing is of equal status to the post-petition claims of retained bankruptcy estate professionals, often the professionals get paid despite vendors being left unpaid. An unpaid post-petition vendor in a case that becomes administratively insolvent should closely monitor the case docket and, depending on the terms of the DIP/cash collateral order, consider objecting to the payment of other administrative claims (such as professional fees) equal in status to post-petition vendor claims unless and until the vendor's administrative claim is fully paid. This right should be preserved in the critical vendor agreement by reserving the right to file any objections, motions, pleadings or applications as the vendor deems necessary or appropriate in the event of the debtor's default.

Conclusion

It is increasingly common that general unsecured creditors receive zero or extremely limited recovery in Chapter 11 cases. Many bankruptcy cases are voluntarily dismissed or converted to Chapter 7 after the debtor's assets are sold or liquidated. Even if the vendor can only convert a portion of its pre-petition claim to administrative status, gaining an administrative claim for post-petition goods sold and payment of even less than 100% of its pre-petition claim and/or a waiver of preference claims being asserted against the vendor may be a wise decision. Such treatment, combined with diligent monitoring of the docket and preparedness to take prompt action if a triggering event occurs, may be likely to yield more of a recovery at the end of the day.

Originally published by Credit Research Foundation.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.