Is Your Case Right for a §503(B)(9) Program? - Using §503(B)(9) to Improve Liquidity and Normalize Vendor Relations

Much has been written about what §503(b)(9) is not: It does not do enough to protect creditors; it gives too much leverage to vendors and not enough to the debtor; it is not clear enough to provide various constituencies with definite implementation guidelines; or it just adds another layer of complexity that has to be dealt with. While all these—and other—criticisms may be true, in the right circumstances, with a little creativity, a lot of cooperation between the debtor and the unsecured creditors, and a proactive approach, §5093(b)(9) can present a rare “win-win” opportunity in chapter 11.

Section 503(b)(9) came about as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). In short, §503(b)(9) gives  vendors an administrative priority claim for "the value of any goods received by the debtor within 20 days before" the date the bankruptcy petition was filed, as long as "the goods have been sold to the debtor in the ordinary course of such debtor's business." In contrast to reclamation claims, there are very limited defenses to §503(b)(9) claims.

The concept a behind a successful §503(b)(9) program is to use the proposed early payment of these administrative claims in exchange for normalized vendor relations, while “paying” for the program with the liquidity benefit captured from reclaiming pre-petition credit terms. If such a program is designed and implemented properly, it will ultimately benefit the debtor through improved liquidity and normalized vendor relations, as well as certain unsecured creditors with §503(b)(9) payments and preference waivers, and will relieve the court of the burden of overseeing all of the foregoing on an ad hoc basis. The more vendors restrict post-petition credit terms, the greater the potential benefit to the debtor from the implementation of such a program.

Anatomy of a §503(b)(9) Program
Given the limited defenses against §503(b)(9) and the potential positive operational impact of such a program, debtors and creditors should quickly look for common ground to launch this effort. However, a case must present the right circumstances to warrant a §503(b)(9) program. The basics of a §503(b)(9) program are simple and consist of three major components:

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• payment of §503(b)(9) claims early in the case;
• agreement by vendors to restore credit terms and promotional programs to pre-petition levels; and
• preference waivers for those vendors who agree to participate in the program.

In order to achieve the maximum benefit of such a program, this return to normalcy should happen as quickly as possible following the debtor’s petition date.

The Terms
For the debtor to be able to offer an enticing program, it must first have enough liquidity to offer early payment of the §503(b)(9) claim. While the timing of the repayments is subject to considerable negotiation, the vendors must be confident that payment of the §503(b)(9) claims will not adversely impact the debtor’s continuing viability. In cases where debtors are strictly managing cash on a daily basis, or are extending terms of payments to achieve sufficient operational liquidity, such a program will not likely be an option. If there is any future risk of administrative insolvency, this would also be ill-advised.

In addition to sufficient liquidity, the vendors’ confidence in the debtor’s performance must also translate into their willingness to offer certain concessions in return for these early payments. In a typical retail chapter 11 case, many of the debtor’s key vendors will reduce payment terms, limit support of promotional activities, and perhaps withhold discounts to protect their interests as signs of difficulty begin to surface. This activity increases exponentially as soon as the debtor files and the vendor is able to quantify the risk associated with pre-petition liabilities. In order for a §503(b)(9) program to be of interest to the debtor, vendors must be willing to restore pre-petition payment terms, promotional support and discounting schemes. In cases where the debtor is having difficulty making post-petition payments or performance continues to decline, the vendor base may not attach enough value to the §503(b)(9) claims to warrant returning to a more traditional set of terms. In other words, a vendor may consider its investment in the debtor through these programs to be unwarranted by the future opportunities post-reorganization.

Finally, it is possible that vendors will request a preference waiver as a further inducement to them to agree to such a program. Remember that in any successful reorganization, these administrative claim payments will be paid in full upon the effectiveness of a reorganization plan, so the early payment is only somewhat compelling. Accordingly, a preference analysis for potential §503(b)(9) vendors will be an essential part of any §503(b)(9) program. A preference analysis is not only essential to the debtor’s economic analysis of any proposed program, but it will also be necessary in gaining support of this program by other constituents and, ultimately, court approval of the program.

The Tools
In order to implement a §503(b)(9) program, each of these major components discussed above should be documented in a written §503(b)(9) agreement. The agreement will be sent to each vendor that is eligible to participate in the program, and execution of such agreement must be a prerequisite to entering the program. At a minimum, each §503(b)(9) should clearly articulate the following:

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• the amount of §503(b)(9) claims per the debtor’s records;
• the minimum credit terms that the vendor extended to the debtor prior to the petition date;
• a preference waiver clause; and
• the consequences to the vendor of a breach of the program terms.

Once a vendor has executed and returned its agreement, then the agreement should provide a period of time during which the vendor is to receive its §503(b)(9) payments. It is preferable to schedule the payments over time instead of all at once, for two reasons. First, it enhances the liquidity benefit to the estate as opposed to paying all the payments at once. Second, because there are likely to be many discrepancies between the debtor’s and vendors’ records, extending the payments over some period will allow for vendors to begin receiving payments, and for the estate to regain its pre-petition credit terms while the debtor and vendor are reconciling their records. The §503(b)(9) agreement should also provide for and describe this reconciliation mechanism. Again, it is best to design this reconciliation process to function on a parallel path with the §503(b)(9) payments so that the parties can begin to enjoy the benefits of the program while the reconciliations are done. In the event agreement on amounts and terms extended cannot be achieved through good-faith negotiations, the agreement should include a mechanism for court intervention to resolve such disputes without putting the vendor’s participation in the program in jeopardy.

If a case is positioned such that the debtor has the liquidity to pay the §503(b)(9) claims early in the case; the vendors are confident enough in the debtor’s post-petition performance they are willing to restore credit terms, give up deposits and re-institute pre-petition promotional programs; and, if necessary, preferences issues can be taken off the table; then the case is probably right for a §503(b)(9) program.

Selling the Program
Because paying §503(b)(9) claims requires court approval, an essential part of any successful program is being able to demonstrate its benefits to the debtor, the other unsecured creditors and the court. In addition, the benefits case must be strong enough to withstand potential objections from non-participants.

The benefits to the debtor will come largely in the form of normalized relations with its vendors as well as improvement in liquidity achieved from restoration of pre-petition credit terms and promotional support. While normalcy of vendor relations is often hard to quantify, this benefit cannot be understated in terms streamlining operational functions. Vendors and the debtor are able to reduce or eliminate the high cost of managing these relationships through their credit or manual accounts payable departments, and can return account management duties to the sales and marketing or purchasing arms of their respective companies. Additionally, any back-office (accounts receivable, accounts payable, cash management, etc.) functions are able to follow their normal protocols as opposed to managing any exceptional policies that were put in place when the debtor filed for bankruptcy protection.

The liquidity benefits from improved credit terms are easier to quantify. For example, assume a vendor provided net/30-day credit terms pre-petition, the debtor purchased $100,000 per month on average from this vendor, and the §503(b)(9) claim for this vendor was $65,000. Post-petition, this vendor reduced its terms to net/7 and required a $25,000 deposit. Under these assumptions, the debtor would achieve an approximate $77,000 increase in liquidity from terms restoration. After applying the deposit and paying the §503(b)(9) claim, the debtor will achieve a one-time net liquidity benefit of approximately $37,000.[1] If the cumulative net liquidity benefit for each of the potential §503(b)(9) claimants is positive, when combined with the operational benefits of normalized vendor relations and the limited impact of the preference waiver, then the debtor should be in favor of the program.

In addition to the §503(b)(9) payments, the vendors will likely request preference waivers as an additional inducement into the program.[2] In addition to the benefits received from the preference waiver, the unsecured creditors should be supportive of the program for two major reasons. First, their §503(b)(9) claims are paid early. In addition, the liquidity benefit to the debtor only improves its ability to continue to pay its post-petition obligations and allows marketing and promotion funding to flow more freely, benefiting both vendor and debtor.

From the court’s perspective, the benefits of such a program are three-fold. First, it furthers the goal of most courts to encourage voluntary settlement of claims between the parties without significant court intervention. Second, it limits otherwise-excessive motion practice that is likely to arise surrounding the demands for allowance and payment of §503(b)(9) claims. Finally, specifically with regard to the preference waivers, it is likely to limit future litigation that the court will have to oversee. 

In every case, there are likely to be objections from nonparticipants in the proposed program. For example, the automatic stay could prohibit vendors with executory contracts from reducing payment terms post-petition. Such vendors may be less likely to have something to offer the debtor in exchange for early payment. This is more prevalent in non-retail bankruptcies where a larger percentage of the vendor community is under contract with the debtor. Therefore, it might be advisable for the debtor to exclude these types of vendors from the program in order to achieve an overall net liquidity benefit. However, this is likely to draw objections or separate §503(b)(9) litigation.

When such objections arise, they should be dealt with proactively. For example, if a contract vendor threatens to be an impediment to the program based its exclusion, all options to renegotiate the contract with the vendor should be explored. In many cases, improved terms in exchange for early assumption of the contract can be negotiated. Such an approach eliminates contract vendors’ net liquidity drag to the program, while at the same time provides the debtor the opportunity to improve contract terms. Debtors should consider negotiating for increased terms beyond prepetition credit, pricing concessions, and/or waivers of reclamation or other pre-petition claims.

By considering the benefits to all constituencies (debtor, unsecured creditors, the court and nonparticipants), it makes selling and defending the program much more likely to succeed.

Conclusion
The concept of a §503(b)(9) program recognizes the inevitable truth in the old adage of “pay me now or pay me later.” Instead of waiting around until the end of the case to pay the §503(b)(9) claims, a §503(b)(9) program will allow the debtor to derive real benefits to the estate from making those payments early in the case. While such a program will not be viable in all reorganizations, if the two  prerequisites of sufficient debtor liquidity and demonstrable benefit from improved credit terms are present, then the debtor should consider implementing a §503(b)(9) program.