A fundamental rule in bankruptcy proceedings is that prepetition claims are not paid without a plan or separate order of the bankruptcy court. The Bankruptcy Code (11 U.S.C. § 101 et seq.) requires payment in a specified order of priority. In large cases, the plan process could take years, leaving a creditor without recovery for an extended period. Orders allowing payment of prepetition claims prior to the payments approved by a plan are rare. One of these rare possibilities is the request to deem a creditor "critical," usually in a first-day motion.
One critical prepetition creditor is an employee of the debtor. Unless a bankruptcy case is filed on a payday, there are unpaid employee wages and benefits that are almost always deemed critical. It is easy to see the need for uninterrupted payments to the debtor's employees because many live paycheck to paycheck and would otherwise seek more stable and assured employment. Further, employee claims enjoy a third and/or fourth priority status for a limited amount of their claims. Critical vendors, however, have no priority under the Bankruptcy Code to justify early payment.
Unpaid vendors and their counsel bombard the debtor with demands for critical vendor treatment at the beginning of a case, sometimes without even understanding the legal requirements for such classification. A debtor often feels extreme pressure to name not only essential creditors as "critical," but also long-time business associates and golfing buddies. The potential for abuse has lead courts to severely limit or deny critical vendor requests in recent years. This article gives a brief description of the issues and evolving case law.
Practical Basis For Critical Vendor Treatment
Quite often, whether true or not, a creditor threatens to cease supplying its product or service to the debtor if its prepetition debt is not paid. The debtor then panics because this is one more disruption early in the bankruptcy case that could thwart its reorganization. If the lack of the product or service would severely impair the debtor's ability to operate, then the loss of the vendor is "critical."
"Critical" is defined as "absolutely necessary for the success of something." Merely because a vendor will not supply its products or services to a debtor, however, is not enough if another similar supplier can replace the allegedly critical vendor. Further, the replacement supplier does not need to be identical to the original supplier. For example, a substantial increase in the purchase price may make the original vendor critical, but a minor inconvenience or moderate price increase alone should not justify critical vendor treatment. Even though there are practical justifications, the debtor must still convince the court it has authority to sidestep the Bankruptcy Code priority scheme.
Legal Basis For Critical Vendor Treatment
Proponents of the critical vendor doctrine argue that a strict rule prohibiting payment of prepetition indebtedness is too inflexible and impractical in a Chapter 11 case. Because the primary goal of reorganization is maximization of value for all creditors, the Bankruptcy Code must contain authority to allow a court to accomplish this purpose. Many courts have relied on Section 105(a) of the Bankruptcy Code as the legal basis for allowing critical vendor payments. Section 105(a) grants bankruptcy courts broad statutory authority to enforce the Bankruptcy Code based on the specific statutory language or equitable common law doctrines.
The "doctrine of necessity" is a creation of equity that is usually a complement to the court's Section 105(a) equitable powers. The doctrine of necessity arises out of the "necessity of payment doctrine" established in railroad reorganization cases in the late 1800's. The doctrine of necessity argues that the critical payments allow for reorganization and a greater recovery to the remaining creditors than they could expect without such critical payments. Without critical vendor payments, therefore, reorganization will fail and the debtor and its estate will suffer substantial harm.
Critical Vendor Doctrine Still Exists, But Now More Difficult To Apply
Most courts allow some form of prepetition critical vendor payments, and many bankruptcy courts have routinely granted critical vendor motions as first day orders. Regardless, the critical vendor concept is the subject of many disputes because of its apparent conflict with the Bankruptcy Code. As the demand for critical vendor treatment increases, more courts are finding ways to control abuse, while still reacting to the practical needs of a debtor.
Disproportionate Harm Supports A Demand For Critical Vendor Status
Texas bankruptcy courts recently established a three part test to determine whether a vendor is really critical. See In re Co-Serv, L.L.C., 273 B.R. 487, 497 (Bankr. N.D. Tex. 2003); In re Mirant Corp., 296 B.R. 427 (Bankr. N.D. Tex. 2003). These courts concluded that Section 105(a) alone could not justify application of the doctrine of necessity. In Co-Serv, the trustee's obligation to protect the going-concern value of the debtor pursuant to Section 1107(a) provided the "bridge" necessary to allow application of the doctrine of necessity through Section 105(a).
The Co-Serv court set forth the following three conditions for evaluating critical vendor treatment:
- the debtor must have a critical need to deal with the specific creditor;
- unless the debtor deals with the creditor, the debtor risks (i) the probability of harm, or, alternatively, (ii) loss of some economic benefit to the estate's going concern value, that is disproportionate to the payment; and
- there is no other practical or legal solution other than payment of the claim. Id. at 498.
These criteria represent a practical way for a debtor to analyze and prove whether a payment is critical.
The Kmart Decision And Court Authority To Pay Critical Vendors
The legitimacy of critical vendor payments was recently called into question in the Kmart bankruptcy case in Illinois. See In re Kmart Corp., 359 F.3d 866 (7th Cir. 2004). In Kmart, the Seventh Circuit affirmed the decision of the district court denying the validity of the bankruptcy court's critical vendor order. Id.
The debtor in Kmart argued for critical vendor payments as follows:
The theory behind the request is that some suppliers may be unwilling to do business with a customer that is behind in payment, and, if it cannot obtain the merchandise that its own customers have come to expect, a firm such as Kmart may be unable to carry on, injuring all of its creditors. Full payment to critical vendors thus could in principal make even the disfavored creditors better off... Id. at 868. Therefore, the debtor concluded, the bankruptcy court could use its Section 105(a) powers to allow such payments.
The Seventh Circuit held, however, that Section 105(a) did not allow critical vendor payments. A bankruptcy court cannot create statutory authority contrary to the explicit priority scheme of the Bankruptcy Code based on Section 105(a). Id. at 869-871. The opinion characterized the doctrine of necessity as "just a fancy name for a power to depart from the Code." Id. at 871.
The Kmart ruling was not an outright rejection of the critical vendor concept, but it does make it much more difficult to apply. In addition to the Section 105 limitation, Kmart suggests compliance with heightened procedural and evidentiary standards is necessary before any payment is deemed critical. At least in the Seventh Circuit, the bankruptcy court should determine whether (i) discrimination among unsecured creditors is the only way to facilitate reorganization and (ii) the disfavored creditors are at least as well off as they would have been had the critical vendor payments never occurred.
The Kmart decision also should affect the timing of critical vendor motions. Critical vendor motions are usually first-day motions that are approved with little or no advance notice to creditors. The Seventh Circuit expressed its concern with expedited approval because it failed to give advance notice to affected creditors. Therefore, even if justification for critical vendor payments exists, other creditors are entitled to adequate notice and an opportunity for a hearing as a prerequisite to granting such relief.
Courts Protect Estates
As stated, Kmart did not completely rule out critical vendor payments. While not part of its holding, the court in Kmart suggested that a debtor may seek authority to pay a prepetition claim outside the ordinary course of business under Section 363(b) of the Bankruptcy Code. Id. at 871. Subsequent to Kmart, a bankruptcy court in the same Illinois district held that the debtor proved critical vendor payments were necessary payments outside the ordinary course of business. See In re National Equip. Services, Case No. 03-27626, Order Pursuant to §§ 105(a), 363 and 364 of the Bankruptcy Code and Granting Debtors the Authority to Provisionally Pay in the Ordinary Course of Business Prepetition Claims of Essential Trade Creditors, (doc. no. 42) (Bankr. M.D. Ill. July 1, 2003).
Also, subsequent to Kmart, the Texas line of reasoning (see supra) was cited favorably in In re CEI Roofing, Inc., 2004 W.L. 2203436 (Bankr. N.D. Tex.). The court in CEI Roofing also suggested (but did not hold) that a creditor could seek relief from the stay against collection of a prepetition debt under Bankruptcy Code Section 362(d) for cause. According to the court, stay relief could provide the "bridge" necessary to authorize critical vendor payments. Id. at p. 8.
Summary
The result of the evolving case law is that critical vendor treatment is more difficult to achieve, but possible. Increased evidentiary standards or a longer notice period might cause some vendors to refuse to work with the debtor. A more likely result is that the creditors will still do business with the debtor and the higher burden of proof will shake out those "critical" vendors that were only looking to improve their position over other similarly situated creditors. Because of Kmart and the Texas cases, all bankruptcy courts have more to consider, which means critical vendor motions are no longer routine.