Not All Creditors Are Created Equal: Critical Vendors and Bankruptcy

Recent economic indicators suggest that the manufacturing industry in the United States has contracted and that the economy may be headed towards recession. Such news is cause for concern for both healthy and struggling companies. A struggling company may be concerned about the prospect of its own bankruptcy filing, but every company is at risk of becoming a creditor in a bankruptcy case.

The level of recovery for a creditor in a bankruptcy case varies dramatically based on the nature of the claim. In the very common scenario where there is not enough money to pay all creditors in full in Chapter 11 bankruptcy cases, unsecured creditors may receive pennies on the dollar – or even nothing at all. Creditors will jostle for position in an attempt to be included in claim classes that take priority over general unsecured claims. For example:

• A creditor who has a first priority, perfected, and unavoidable lien on collateral of the bankrupt party (the debtor) can typically expect to be paid in full up to the value of the collateral.
• A creditor who provides goods and services to a debtor following the bankruptcy filing is entitled to administrative expense claims that must be paid in full in order for debtor to confirm a plan of reorganization.
• A creditor who provides goods delivered to the debtor within 20 days prior to the bankruptcy filing is entitled to an administrative expense claim for the value of such goods.

For the less fortunate unsecured creditor who provided services (rather than goods), or provided goods outside the 20-day pre-bankruptcy period, the default under the law is that the creditor is entitled to nothing more than a general unsecured claim. For this creditor, the best case scenario in bankruptcy may to obtain designation as a critical vendor who is providing goods or services necessary to the debtor’s survival. A designated critical vendor’s pre-bankruptcy claim will be paid in full, subject to certain conditions.

The term “critical vendor” does not appear anywhere in the Bankruptcy Code. Rather, the concept has been developed over time by bankruptcy courts and other participants in the Chapter 11 process. The issue arises from the fact that, unless there is an enforceable contract providing otherwise, a debtor cannot compel a creditor to continue to do business with it. Note that a creditor threatening to cease doing business with the debtor unless the creditor’s pre-bankruptcy claim is paid in full may be accused of violating the automatic stay. If the creditor has no binding contract, and does not make any such threat, however, there is nothing to stop the creditor from no longer doing business with the debtor. In many cases, a debtor who has been cut off by a creditor can simply purchase from the creditor’s competitor as an alternative. But, if the creditor is a sole source supplier or otherwise provides goods or services that are very difficult to replace, the debtor may find itself struggling to reorganize. In such circumstance, the debtor may deem the creditor “critical” and seek authority from the bankruptcy court to pay the creditor’s pre-bankruptcy claim in full. Debtor’s usually offer such designation on the condition that the creditor continue supplying the debtor on the same credit terms as were in place prior to the bankruptcy filing.

In large to mid-size Chapter 11 bankruptcy cases, critical vendor motions are quite typical. Such motions are filed at the beginning of the case and allow for a certain amount of funds to be used by the debtor to pay the claims of critical vendors. Most often, the debtor will be the party determining which creditors are deemed critical. However, other parties in the case such as the senior secured creditor with a lien on cash, or the official committee of unsecured creditors, may have a say in how determination is made and how the funds are paid.

Creditors seeking critical vendor status face several challenges, including:

• At the most fundamental level, the creditor must convince the debtor that they should be included on the list of critical vendors. Whether a creditor is entitled to be included can differ from jurisdiction to jurisdiction, depending on applicable case law. A common test adopted by many courts requires a critical vendor to demonstrate each of the following:
  
  
1. dealing with the creditor is virtually indispensable to the profitable operations of the debtor;
2. a failure to deal with the creditor risks probable harm or eliminates an economic advantage disproportional to the amount of the claim; and
3. there is no practical or legal alternative to payment of the claim.
   
   
• The standard for determining whether a creditor will be deemed critical can vary widely across jurisdictions and the approach can even differ from judge to judge within a single jurisdiction. In some jurisdictions, millions of dollars in critical vendor claims are routinely paid via a “first day” motion filed at the beginning of the case. In other jurisdictions, the issue may be involve a contentious dispute resulting in a court order not allowing for any meaningful amount of critical vendor payments.
• Designating a claim as critical will usually come with strings attached. As a condition to being paid, the creditor likely will be required to provide the debtor with reasonable credit terms for a particular period of time. Thus, debtors can use critical vendor motions as leverage to obtain post-bankruptcy credit terms from parties that otherwise would likely require the debtor to pay in advance. Critical vendors incur a relatively small amount of risk in providing credit on a go-forward basis to the debtor. If the debtor later falters in bankruptcy and is forced to liquidate, the creditor will have an administrative expense claim for such post-bankruptcy receivables. While administrative expense claims will not be paid in full if a debtor is “administratively insolvent,” such a claim is greatly preferred to general unsecured status.
• Creditors who are vying for critical vendor treatment must be careful not to frame their efforts as an ultimatum. Once again, threats to supply a debtor only on the condition that a pre-bankruptcy claim be paid in full can be seen as a sanctionable violation of the automatic stay. Because the line between sanctionable threat and forceful request can be fuzzy, creditors are well advised to have experienced bankruptcy counsel assist with the matter.

Ultimately, critical vendor treatment can be the answer to the prayers for a creditor who finds itself owed a significant amount of money by a bankrupt party. The main point to remember is that critical vendor treatment, by definition, is an extraordinary step taken by debtors to ensure their economic survival. Creditors should recognize that some other general unsecured claimants will also be seeking this special treatment. While only a select few may make it onto the list, the time and effort taken to be included is often well worth it.