In the ‘90s as Delaware sought to become a popular venue for Chapter 11 business filings (also known as the “Full Employment for Delaware Bankruptcy Lawyer’s” movement), the judges in Delaware became increasingly liberal in allowing “critical” vendors to be paid. Initially, the motions specified a few truly critical vendors and explained the reasons why it was necessary to pay these select suppliers. As the months and years passed, the critical vendor motions contained less and less justification and were offered to more and more pre-petition vendors. Other districts which also wanted to be “popular” filing sites quickly jumped on board the critical vendor bandwagon.

When the K-Mart Corporation was filed in Chicago in January of 2002, there were immediate first day motions asking the bankruptcy judge to authorize payment of $340,000,000 to 2,230 unidentified “critical” vendors. When the critical vendor payments were approved, Capital Factors, an unsecured creditor in the case, appealed to the District Court. The Federal District Court subsequently reversed the bankruptcy court’s order saying that the payments were not authorized under the Bankruptcy Code. K-Mart then appealed further to the Seventh Circuit Court of Appeals asking that the District Court be reversed and the payments approved.

On February 24, 2004, the Seventh Circuit ruled that the District Court had been correct and that K-Mart type critical vendor payments are not allowed. But the Seventh Circuit did not totally slam the door shut. The Court was clear, however, that “critical vendor” as it became popular in the 90s, was merely “a fancy name for a power to depart” from the priorities set out in the Code.

In K-Mart, debtors’ counsel sought court approval, on the first day of its bankruptcy, to pay in full, the pre-petition claims of all critical vendors. There was virtually no testimony offered in support of the motion. Indeed, such a broad sweeping request by the debtors on the first day of the case was itself evidence that debtors and their counsel wanted carte blanche to pay whoever they chose in whatever amount they might negotiate.

The Seventh Circuit looked at the whole body of unsecured creditors and saw both favored (“critical”) creditors and disfavored creditors who would not receive the special treatment. The Court said approval of critical vendor payments would require a showing that the special treatment of favored creditors would actually benefit the entire body of creditors by leaving the disfavored creditors better off (or at least not worse off) than if the payments had not been made.

The Seventh Circuit said that the K-Mart critical vendor payments should be recovered by the estate and found that the vendors would suffer no injury by having to disgorge (other than giving back what they were improperly paid).

The Court provided some suggestions for future bankruptcies:

• debtors can assure vendors of post-petition payment by paying COD or Cash in Advance, and 
• vendors can be protected with a stand-by letter of credit on which the bankruptcy court could authorize unpaid post-petition vendors to draw.

Additional suggestions: 

• If you are to be treated as a critical vendor, be sure there is adequate notice to all creditors and an evidentiary record that your company’s goods or services are truly critical to the debtor and that - absent payment - you will no longer deal with the debtor; show the harm to the debtor if you refuse to sell and the overall benefit to be gained from your participation. 
• Before you refuse to deal with the debtor be sure you do not have a contractual obligation to do so. 
• If you have a contract with the debtor, push for prompt assumption which requires payment of pre-petition arrearages. 
• Promptly assert your reclamation rights when you become aware of the debtor’s insolvency. 

If you have questions regarding this publication, please contact Judy Thompson at (704) 342-5299 or  jdthompson@poynerspruill.com.

This electronic publication is published by Poyner & Spruill LLP to provide general information about significant legal developments. Because the facts in each situation vary, the legal precedents noted herein may not be applicable to individual circumstances.