Considerations for the Trade Creditor Seeking Critical Vendor Status

Since Hon. Frank Easterbrook’s decision in the Kmart bankruptcy, [1] scholars and attorneys have commented on the decision and voiced their opposition to critical vendor orders in bankruptcy proceedings, yet such orders are still prevalent in bankruptcy cases. There has been limited discussion as to risks to the trade creditor of accepting critical vendor status. While a trade creditor is unlikely to decline treatment under critical vendor orders, those that qualify should negotiate the terms to limit the impact it has on their rights.

Common Critical Vendor Requirements
The requirements for critical-vendor status usually require a debtor establish that (1) it is critical that the debtor deal with the creditor, (2) the failure to deal with the creditor risks probable harm or eliminates an economic advantage disproportionate to the amount of the claim and (3) there was no practical or legal alternative to payment of the creditor’s claim, such as a deposit (the “CoServ test”). [2] In addition to the CoServ test, critical vendors usually are required to comply with additional requirements.

First, a critical vendor must typically agree to deal with the debtors on “customary trade terms,” which have been defined as “those trade terms, which include, but are not limited to, credit terms, credit limits, historical pricing conventions, historical product volumes, cash discounts, timing of payments, allowances, rebates normal product mix and availability and other applicable terms and programs acceptable to the Debtors, that were most favorable to the Debtors and in effect between such critical vendor and the Debtors at any time during the [12-] month period preceding the Commencement Date.” [3]

Additionally, if a creditor refuses to continue to provide product, supplies or services on customary trade terms after receipt of a critical vendor payment, critical-vendor orders may provide the debtor with remedies, such as (1) declaring that any payment made to such critical vendor on account of its pre-petition claim shall be deemed to have been in payment of then-outstanding post-petition claims of such critical vendor without further order of the court or action by any person or entity; (2) requiring that the critical vendor immediately repay to the debtors any payments made to it on account of its pre-petition claim, without the right of any setoffs, claims, provision for payment of reclamation or trust fund claims, or otherwise; and (3) seeking redress with the court for failure to comply with the customary trade terms. [4] Thus, in order to receive and keep any payment under a critical-vendor order, the vendor must continue doing business with the debtor on generous terms for an unspecified time period.

Important Considerations for Critical Vendors
What should a creditor and its counsel consider when negotiating in a critical vendor order? First, one should ask the following questions: Is doing business with the debtor critical for the creditor’s survival? Is the pre-petition claim relatively small as compared to the post-petition credit exposure if the case turns administratively insolvent? How much of the pre-petition claim would be an administrative-expense claim under § 503(b)(9) of the Bankruptcy Code? Does the debtor anticipate a 100 percent plan? If the risk of doing business with the debtor post-petition outweighs the benefits of being paid some or all of your pre-petition claim (and you do not need the debtor’s business for your own survival), then perhaps it may not make sense to become a critical vendor.

Second, critical-vendor orders generally require that you agree to the customary trade terms governing the post-petition relationship between the parties. A written document memorializing the agreed-to customary trade terms between the parties, and the critical-vendor order should adopt the agreed upon definition in the event of a dispute in the future. It may also make sense to have current stated invoice or agreed contract terms approved by the court in the critical-vendor order.

Third, creditor should request a notice and cure period relating to any default under the agreement or order. Situations can arise beyond anyone’s control that can result in a technical default under the order. A provision affording a vendor a notice and cure period or the ability to reach an alternative agreement would offer flexibility if circumstances change.

Fourth, debtors often reserve various rights in critical vendor motions that, while they may not be addressed directly in the order, nonetheless may impact the creditor’s decision to accept critical-vendor treatment. These reservations usually include the right to (1) object to the amount or validity of the critical vendor’s pre-petition claim even after it has been paid under the order; (2) assume or reject any agreement, contract, program, policy or lease under § 365 of the Code with the critical vendor; and (3) permit the debtor to refuse any services or shipment of goods at any point in the future.

Critical vendors may want to not permit the debtor or a subsequent trustee to object to the critical vendor’s pre-petition claim at an undefined later date after the creditor has provided valuable services to the debtor under favorable terms. At a minimum, the vendor should negotiate the allowance of its claim or an objection deadline to its claim 60-90 days after the order is entered. Otherwise, the consideration for accepting critical-vendor treatment may need to be repaid to the estate. Given that the debtor also often reserves the right to cease doing business with the critical vendor at any time without notice, the vendor may want a 30- or 60-day termination-notice period before the debtor can cease doing business with the vendor or a corresponding right to stop doing business with the debtor after some reasonable period of time.

Fifth, most critical-vendor orders do not address potential chapter 5 causes of action against the creditor. The following is an example of why a vendor may want to consider the impact of avoidance action claims in the decision process.

Assume that the vendor did not receive any payments 90 days prior to the petition date and is approved as a critical vendor. That creditor may be entitled to the full amount of its pre-petition claim without incurring any preference exposure. In a different scenario, now assume that the vendor received regular payments in the 90 days before the petition date up to the week before the debtor filed for bankruptcy. While that vendor may receive all remaining funds owed to it under the critical-vendor order, the critical vendor can still be sued on all payments received during the 90 days prior to the petition date as a preference. This possible result may impact the motivation to do business with the debtor post-petition on customary trade terms.

The post-petition payment on any unpaid new value pursuant to a critical-vendor order could conceivably impact a new-value defense to any preference action in minority jurisdictions that require the new value remain unpaid, such as the Seventh Circuit. Accordingly, a critical vendor with extensive payments within 90 days of the filing should consider pushing for a release or obtain a waiver in the critical vendor order relating to any chapter 5 cause of action. Other types of orders authorizing payment on pre-petition claims—including lease and contract assumption orders and 9019 orders, among others—often include waivers of avoidance actions.

Conclusion
While there are many good reasons to be a critical vendor in a bankruptcy proceeding, until Congress provides clear guidance for the treatment of so-called critical vendors, it is of the utmost importance to carefully consider whether it is best for the creditor under the circumstances and if so, to negotiate the above-mentioned terms in any critical-vendor order.