Critical Vendor Payments: What are They and When do Bankruptcy Courts Authorize Them?

Vendors are sometimes presented with customers going into bankruptcy. Vendors experienced in this dilemma are aware of preference actions pursuant to 11 U.S.C. § 547(b), whereby the trustee seeks to recover from the vendor all payments received from the debtor within the 90 day period prior to petition. There are various mechanisms and defenses a vendor can employ to block preference action recovery. One such tool is the critical vendor doctrine. This blog examines the steps a vendor must take to successfully implement the critical vendor doctrine in Florida bankruptcy courts.

We were recently asked by a client whether it could claim critical vendor status in defense of a preference action. Our first question was: “Did you refuse to do business with the debtor when you learned of its bankruptcy?” Client’s answer: “No. We have continued doing business with debtor after petition, but on cash-in-advance payment terms.” Our response: “Sorry, but critical vendor status does not apply here because you did not refuse to do business with the debtor absent a critical vendor payments order by the court.” In a well-drafted critical vendor payments order, the debtor is allowed to immediately pay vendor for prepetition debts that would otherwise be treated as normal unsecured creditor debt and paid pennies on the dollar after plan confirmation. In exchange, vendor agrees to continue providing its goods or services to debtor, with debtor making payments during pendency of the bankruptcy on defined payment terms.

The first step to successfully implement the critical vendor doctrine is to inform your customer (soon-to-be or already bankruptcy debtor) that you refuse to continue supplying your goods or services unless the bankruptcy court enters an order determining you to be a critical vendor and ordering critical vendor payments upon specific terms – this step should be well documented for use as evidence. You ask your customer to file a critical vendor motion in the first few days of the bankruptcy case and you negotiate the terms. If customer, in its business judgment, feels that your goods or services are critical to customer’s continuing business, it will agree to file the motion. The motion should identify the vendor, the amount to be paid to vendor, and the specific reasons why that vendor is so essential to the debtor’s reorganization efforts.

Next, you and debtor must prove to the court that it should grant the motion. Courts will only authorize payment of pre-petition amounts to critical vendors when: (1) those critical vendors are indeed critical and have refused to do business with a debtor absent payment; and (2) only if the court finds that the disfavored creditors will be at least as well off as a result of the court’s granting critical vendor status to the select vendors.  In re Tropical Sportswear Int’l Corp., 320 B.R. 15, 20 (Bankr. M.D. Fla. 2005); In re News Publ. Co., 488 B.R. 241, 244 (Bankr. N.D. Ga. 2013) (citing Tropical Sportswear).

Stated differently, payment of critical vendors should be approved only upon an evidentiary showing that (1) the payments were necessary to the debtor’s reorganization; (2) that a sound business reason justified the payments, in that the vendor would refuse to do business with the debtor absent the payments; and (3) that the disfavored creditors would not be harmed by the payments. Osborne v. Howell Electric Motors (In re Fultonville Metal Prods. Co.), 330 B.R. 305, 313 (Bankr. M.D. Fla. 2005); Bender Shipbuilding & Repair Co. v. Analtytical Chemical & Testing Inc., (In re Bender Shipbuilding & Repair Co.), 2012 Bankr. LEXIS 4254 (Bankr. S.D. Ala. 2012) (citing Fultonville).

In Tropical Sportswear, the debtor presented evidence to the court showing that (a) the critical vendor provided the debtor with unique products and services used in the manufacturing of debtor’s products; (b) it would take approximately four to six weeks to replace the critical vendor with an alternate supplier; and (c) interruption in the flow of services and products will substantially jeopardize the debtor’s ability to conduct business. In re Tropical Sportswear Int’l Corp., 320 B.R. 15, 20. Based on this showing, the court held that the critical vendor payments were necessary. Id at 20-21. The court went on to find that the net effect of the critical payment orders on the non-critical creditors was positive. Id. Of some relevance was that the critical vendor terms were negotiated at arms-length by and between the parties, including the creditors’ committee. Id

The burden of proving critical vendor is challenging. A request to pay selected prepetition vendors is a clear departure from basic bankruptcy precepts. Consequently, such a request should be carefully scrutinized, and only granted when the circumstances establish that the selected payments are necessary to the reorganization case and will ultimately benefit all creditors of the estate. Fultonville, 330 B.R. 305, 313.

In conclusion, the critical vendor doctrine should be considered as an option only where the vendor’s goods or services are actually essential to the customer’s future business. If you are presented with this circumstance, it would be wise to involve your attorney immediately.