The critical vendor roller coaster.(credit column)

The critical vendor doctrine has had its ups and downs over the past couple of decades. First came the frequent court orders that approved a debtor's request to pay the pre-petition unsecured claims of certain favored "critical vendors" whose goods and/or services were considered essential for the debtor's business. Then some courts pulled back, rejecting debtors' requests for favored treatment of so-called "critical vendors" where the debtor could obtain the same goods and/or services from other vendors. Then came the decision of the United States Court of Appeals for the Seventh Circuit, in the Kmart case, that rejected preferred treatment for critical vendors and suggested a drastic cutback of availability of critical vendor relief. Some commentators went as far to pronounce the death of the critical vendor doctrine in light of the Kmart decision.

Despite the Kmart decision, in certain jurisdictions, the courts have continued to approve preferred treatment of critical vendors' pre-petition claims. However, some courts are continuing to question the applicability of the critical vendor doctrine. Most recently, the United States Bankruptcy Court for the District of New Hampshire, in In re Zenus is Jewelry, Inc., denied a Chapter 11 jewelry retailer debtor's request to pay certain vendors' pre-petition claims, based on the critical vendor doctrine, because the vendors did not provide a unique product for which they were the only source and there were other vendors willing to sell to the debtor on a C.O.D. basis. And, creditors considering accepting a critical vendor payment from a debtor should think twice and read the fine print of the critical vendor order and any agreement the vendor is asked to execute. In another recent decision, the United States Bankruptcy Court for the District of Delaware, in In re Meridian Automotive Systems, Inc., compelled the return of a critical vendor payment because the creditor had violated the critical vendor orders and trade agreement with the debtor by attempting to increase the price of its goods and then refusing and delaying delivery of goods to the debtor during the Chapter 11.

History of the Critical Vendor Doctrine

Prior to the Kmart decision in 2004, Chapter 11 debtors were frequently obtaining court approval of payment of the pre-petition unsecured claims of certain favored critical vendors prior to confirmation of a Chapter 11 plan. The courts approving critical vendor payments relied on the "necessity of payment" doctrine adopted by the United States Supreme Court prior to the enactment of the Bankruptcy Code and the bankruptcy court's equitable power under Bankruptcy Code Section 105 to "issue any order, process or judgment that is necessary or appropriate to carry out the provisions of this title." The courts ruled that the critical vendor payments had to be necessary for the debtor's reorganization and successful business operation. Most of these courts also conditioned the debtor's payment of pre-petition critical vendor claims upon the creditor's agreement to continue extending credit to the debtor during the Chapter 11 case. This elevated the lower priority pre-petition unsecured claims of participating critical vendors to higher priority Chapter 11 administrative priority claims that were more likely to be paid.

Preferred treatment for critical vendors became an exception to the claims priority rules. Claims are supposed to be paid based on where they stand on the claims priority ladder. Secured and lien creditors are at the top of the priority ladder and are entitled to preferred treatment from the proceeds of their collateral. Administrative claims owing to creditors for the goods and services they provide to the debtor during the bankruptcy case are on the next lower rung of the priority ladder. Creditors holding lower level priority claims, such as wage, salary, benefit, tax and other claims, are entitled to payment from the debtor's unencumbered assets, after the full payment of all higher priority administrative priority claims. Pre-petition unsecured claims occupy the lowest creditor rung of the priority ladder and are not entitled to receive any distribution from the debtor until the higher priority creditors are paid in full.

However, not all courts approved preferred treatment for critical vendors' pre-petition claims. Some courts, including certain Circuit Courts of Appeal, denied the payment of critical vendors' pre-petition unsecured indebtedness prior to confirmation of a Chapter 11 plan based upon the general claims priority rules that require the full payment of higher priority claims before any payment could be made to lower priority pre-petition unsecured claims, and the absence of any Bankruptcy Code provision that authorized such payments.

And some courts that acknowledged the bankruptcy court's power to approve a Chapter 11 debtor's payment of critical vendors' pre-petition claims have not routinely approved such payments. For instance, the United States Bankruptcy Court for the Northern District of Texas in In re Coserv, L.L.C. conditioned critical vendor payments on the debtor's proof that (1) the vendor was indispensable to the debtor's profitable operations or the preservation of its bankruptcy estate because the vendor was a major customer of the debtor, the sole supplier of a particular product the debtor needed or controlled a valuable property the debtor needed; (2) the payment of the vendor's pre-petition claim would result in meaningful economic gain or the avoidance of serious economic harm to the debtor that materially exceeded the amount of the payment, which cannot be satisfied merely by the promise of favorable credit terms; and (3) there was no practical or legal alternative to dealing with the vendor, except by paying its pre-petition unsecured claim, which cannot be satisfied if there were other vendors willing to sell to the debtor on cash in advance terms, based on receipt of a deposit or letter of credit or on any other basis.