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Potential Pitfalls in Critical Vendor Negotiations

In 2002 the U.S. Bankruptcy Court for the Northern District of Texas issued an opinion in the case of In re CoServ,[1] establishing a three-part test to determine whether a debtor should be authorized to pay prepetition claims of "critical" vendors,[2] which is still widely relied upon today.  The Bankruptcy Code[3] generally prohibits a debtor from paying prepetition claims outside of a confirmed chapter 11 plan of reorganization.  This presents a conundrum for debtors that cannot continue operating without goods and services from its vendors, because vendors are often unwilling to extend any additional credit or continue doing business with a customer in bankruptcy.  Bankruptcy courts will sometimes authorize payment of vendors' prepetition claims as necessary for the debtor to continue its operations, so that it may have an opportunity to reorganize in chapter 11.  These vendors are commonly known as "critical vendors."  Being approved as a critical vendor is hugely advantageous, because vendors' unpaid receivables are unsecured claims that often receive pennies on the dollar, if anything at all, in bankruptcy.  Obtaining critical vendor status is typically a vendor's only chance of being made whole by a customer in bankruptcy.  Vendors are therefore incentivized to condition future business with the debtor on payment of their prepetition claim.  The CoServ opinion is highly relevant in this regard. 

The court reiterates in CoServ that payment of prepetition claims outside of a chapter 11 plan should only be authorized in extraordinary circumstances, noting the fundamental bankruptcy policy of treating similarly situated creditors equally.[4]  The court also advances a significant position with respect to a debtor's trade creditors, which is that, under certain circumstances, a vendor could violate the automatic stay by refusing to do business with a debtor in bankruptcy. 

To be clear, this post is not to suggest that any supplier or vendor is obligated to continue doing business with a customer once it files bankruptcy.  The CoServ opinion makes that clear, and other courts have disagreed that a trade creditor's refusal to do business with a debtor could violate the automatic stay in the first place.  Nonetheless, the court's position CoServ is pertinent knowledge for any vendor dealing with a customer in bankruptcy. 

The crux of the Court's opinion is that vendors should not leverage their "critical" status to extort payment of prepetition claims.  Vendors familiar with the bankruptcy process know that, unless they are a critical vendor, they typically have two chances of being made whole on prepetition receivables: slim and none.  Thus, even if a vendor is willing and able to continue supplying the debtor without being paid on its prepetition claim, there is a strong incentive for them to condition any post-petition orders on status as a critical vendor.  The Court curbs that incentive by positing that the supplier's refusal could violate the automatic stay, specifically Bankruptcy Code section 362(a)(6), which prohibits creditors from taking "any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the case…."[5]  The court states as follows:

The goal of equal treatment in liquidation or under a plan suggests Congress would not countenance use by a general unsecured prepetition creditor of a "critical" position to force payment of a prepetition debt. Section 362(a)(6) on its face appears to prohibit such "economic blackmail."[6]  …

The Court would reiterate that the irreplaceable supplier which uses its leverage to extort payment of a prepetition debt may violate 11 U.S.C. § 362(a)(6).  It is at a minimum clear that "economic blackmail" is a most dubious rationale for invoking the Doctrine of Necessity.[7]

The Court's position must be considered in context; otherwise, it could be misconstrued as giving a debtor-in-possession extraordinary powers to compel trade creditors to supply bankrupt customers against their will.  The Court is careful to clarify that no creditor is obligated to continue supplying a debtor at risk of its own peril, and it recognizes creditors' need for additional assurances of payment for any post-petition orders.[8]  The Court is not speaking to any refusals to supply a debtor.  When referring to "economic blackmail," the Court is addressing instances in which the debtor is able to protect a supplier from any risk associated with post-petition orders (via a deposit, C.O.D. terms, payment in advance, etc.), and the supplier is otherwise able to continue filling the debtor's orders,[9] but the supplier nonetheless refuses to continue supplying the debtor in an effort leverage payment of its prepetition claim.  In that situation, the Court reasons that the supplier's only reason for refusing post-petition orders is to leverage payment of its prepetition claim, which the Court believes entitle the debtor to invoke the protections of section 362(a)(6).[10] 

Other courts disagree that a supplier's refusal to continue doing business with the debtor could ever be a violation of the automatic stay.  One example is the case of In re Lucre, Inc.,[11] where the debtor sought to compel one of its creditors (SBC) to continue performing under a prepetition executory contract, known as an interconnection agreement, even though the debtor was in default to SBC at the time of the bankruptcy filing.[12]  The court first rejected the debtor's argument that it could, without assuming the agreement, compel SBC's performance under Bankruptcy Code section 365.[13]  More importantly, the court also rejected the debtor's argument that SBC's refusal to perform violated the automatic stay as an attempt to collect its prepetition claim, noting that SBC could have had numerous valid reasons for its refusal other than attempting to collect its prepetition claim, including that it "simply doesn't do business with Chapter 11 debtors."[14]  The court also takes the position that section 362(a)(6) prohibits affirmative actions taken by creditors, and that refusing to continue doing business is not an "act" prohibited under that section.[15] 

In summary, while CoServ is not cause for vendors to second guess their decision to stop doing business with a customer in bankruptcy, or to have reservations about negotiating the terms on which they are willing to continue doing business, the opinion does illustrate the pitfalls that can arise for vendors seeking treatment as a critical vendor.  Vendors are encouraged to retain experienced legal counsel as part of their good faith critical vendor negotiations to avoid these potential pitfalls. 

[1] 273 B.R. 487 (Bankr. N.D. Tex. 2002). 

[2] The court states the test is as follows:

First, it must be critical that the debtor deal with the claimant. Second, unless it deals with the claimant, the debtor risks the probability of harm, or, alternatively, loss of economic advantage to the estate or the debtor's going concern value, which is disproportionate to the amount of the claimant's prepetition claim. Third, there is no practical or legal alternative by which the debtor can deal with the claimant other than by payment of the claim.

Id. at 498. 

[3] 11 U.S.C. §§ 101, et seq.

[4] Id. at 493-94 ("Except where an unsecured claim, non-payment of which could impair a debtor's ability to operate, has been accorded priority treatment by Congress and existing senior creditors consent or are clearly provided for, a bankruptcy court may order payment of unsecured prepetition claims only under the most extraordinary circumstances. … [T]he entire scheme of the Bankruptcy Code favors equal (and simultaneous) treatment of equal allowed claims…").

[5] See 11 U.S.C. § 362(a)(6). 

[6] Id. at 494 (citing In re Structurlite Plastics Corp., 86 B.R. 922, 932 (Bankr. S.D. Ohio 1988)). 

[7] Id. at 499 n. 22 (citing Russell A. Eisenberg & Frances F. Gecker, The Doctrine of Necessity and Its Parameters, 73 Marq. L. Rev. 1, 38 (1989); In re Structurlite Plastics Corp., 86 B.R. 922, 932 (Bankr. S.D. Ohio 1988)).  Section 362(a)(6) prohibits creditors from taking "any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the [bankruptcy case]."  11 U.S.C. § 362(a)(6).

[8] Id. at 494-95 ("This is not to say that the creditor placed in dire straits by a debtor's bankruptcy must supply the debtor when to do so would risk its own insolvency. Mechanisms such as a deposit by the debtor, payment on delivery, payment in advance, letters of credit and consignment of goods are available to ensure against further loss by such a creditor. If means of this sort are inadequate, the case may fit the standards fixed by the Court, infra.").

[9] One of the requested critical vendors in CoServ was a "small 'ma and pa' operation" that did not believe it could afford to acquire goods necessary to continue supplying the debtors absent payment of its prepetition claim.  Since the testimony showed that a deposit or prepayment from the debtors could mitigate the problem, the court denied the debtor's critical vendor motion as to this creditor.  Id. at 499-500.  The Court states in a footnote that it "recognizes even the temporary loss of $2,803 may be painful for a small company," but that "at least absent a showing that [the company] will go out of business to Debtor's detriment if its claim is not paid, [the company's] needs cannot affect the Court's decision."  Id. n. 23. 

[10] Id. at 499 ("If the creditor is within the Court's reach and the claimant's use of its leverage violates the automatic stay, the Court may provide a remedy as effective as payment of the claim.").

[11] 339 B.R. 648 (Bankr. W.D. Mich. 2006).

[12] SBC sought relief from the automatic stay to seek relief in state court from prepetition state court injunctions precluding SBC from discontinuing services under the agreement, even though the debtor was in monetary breach of the agreement.

[13] Id. at 657-58.

[14] Id. at 658 ("There are several problems with this argument. The inference that [debtor] advocates is not the only inference that can be drawn from SBC's refusal to perform post-petition. Granted, the reason for refusing to perform even when the bankruptcy estate is offering C.O.D. terms for post-petition performance could be the party's desire to recover its prepetition claim. However, there could be other reasons as well: the debtor's performance has been poor; a competitor is offering a better deal; the other party simply doesn't do business with Chapter 11 debtors.").

In this regard, the court rejects the inference that seemingly underlies the Court's position in CoServ

[15] Id. ("The specific language of Section 362(a)(6) also presents a problem, for that subsection stays only an 'act to collect, assess or recover a claim.' An 'act' is defined as 'the doing of a thing.' Webster's Ninth New Collegiate Dictionary. However, in this instance, SBC is not accused of doing anything. To the contrary, Lucre's complaint is that SBC is doing nothing. Indeed, what Lucre wants is for SBC to perform notwithstanding SBC's belief that it has a legitimate basis not to perform.").