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he bankruptcy courts continue to struggle over their power to approve a debtor’s payment of the

pre-petition claims of certain favored critical vendors who are supposedly essential to the success of the debt-or’s business and reorganization prospects. While the bankruptcy courts in Delaware and the Southern Dis-trict of New York have been approving critical vendor orders, other courts have imposed more stringent requirements resulting in denial of critical vendor relief.

The criteria that a bankruptcy court considers when deciding a critical vendor motion has again come to the fore in the Corner Home Care, Inc. bankruptcy case pending in the United States Bankruptcy Court for the Western District of Kentucky. The Corner Home Care court refused to treat a key supplier as a critical vendor, rejecting payment of the supplier’s pre-petition claim during the debtor’s Chapter 11 case. The court applied

a more stringent three-part test that a debtor must sat-isfy to obtain approval of a critical vendor order. The debtor must prove (1) the vendor is really “necessary” for the debtor’s successful reorganization; (2) the debt-

or exercised “sound business judgment” in preferring the vendor and (3) such favorable treatment did not prejudice the debtor’s other unsecured creditors.

Trade creditors obtaining critical vendor status should also be cognizant of the continued risk of preference exposure. The courts have ruled that critical vendors continue to be exposed to preference liability unless it is waived or released in the order approving critical ven-dor treatment. Critical creditors are also at risk of los-ing the benefit of the new value defense to preference liability for invoices that were paid post-petition under the critical vendor order. This risk raises uncertainty about the extent of relief that a critical vendor order really provides.

FactsOn December 28, 2009, Corner Home Care, Inc. (“Cor-ner Home Care”) filed for Chapter 11. Corner Home Care sought court approval to designate H.D. Smith and several other creditors as critical vendors and sought payment of their pre-petition claims. While the court denied this motion, Corner Home Care paid the sum of $141,075.47 toward H.D. Smith’s pre-petition invoices, as they came due, shortly after the Chapter 11 filing. While these invoices were for goods H.D. Smith had sold to Corner Home Care within 20 days of its bankruptcy filing and were, therefore, entitled to administrative priority status under Section 503(b)(9) of the Bankruptcy Code, that did not change the fact

The Corner Home Care court refused to treat a key supplier as a critical vendor, rejecting payment of the supplier’s pre-petition claim during the debtor’s Chapter 11 case.

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Critical Vendor Update

Bruce Nathan, Esq.

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that Corner Home Care paid these invoices without court approval in violation of Section 549 of the Bankruptcy Code.1

In an effort to satisfy Section 549 after the fact, Corner Home Care again moved for court approval of its post-petition pay-ments to H.D. Smith as critical vendor payments. Corner Home Care asserted the necessity of these payments in response to H.D. Smith’s threat to stop selling to Corner Home Care on the same pre-petition terms, unless H.D. Smith’s pre-petition invoices were paid.

Corner Home Care had been purchasing pharmaceuticals and durable medical equipment from H.D. Smith. Corner Home Care had previously purchased its pharmaceuticals from AmerisourceBergen and some of its durable medical equip-ment from Invacare. H.D. Smith ended up getting this busi-ness because it was more cost effective than its competitors. H.D. Smith could sell goods to Corner Home Care on an as-needed basis by next-day shipping. That enabled Corner Home Care to reduce its inventory and thereby reduce the number of warehouses and pharmacies it needed to operate. While AmerisourceBergen had offered to sell goods to Corner Home Care on cash terms during the bankruptcy, Corner Home Care contended that it could not shift its purchases to AmerisourceBergen because Corner Home Care lacked suffi-cient cash and available financing.

The history of Critical Vendor TreatmentPrior to the Bankruptcy Code, the courts had granted critical vendor motions based on the “necessity of payment” doctrine that the United States Supreme Court had recognized in its 1882 decision in Miltenberger v. Logansport Railway. The Supreme Court had approved a debtor’s post-petition pay-ment of the pre-petition claims of those creditors who were found to be necessary for the rehabilitation of the debtor’s business and to its reorganization. Subsequent to the enact-ment of the Bankruptcy Code, the courts also granted critical vendor relief based on the bankruptcy court’s equitable power under Bankruptcy Code Section 105 to “issue any order, pro-cess or judgment that is necessary or appropriate to carry out the provisions of this title.”

The courts relying on the “necessity of payment” doctrine and Bankruptcy Code Section 105 in granting critical vendor motions had generally conditioned the debtor’s payment of pre-petition critical vendor claims upon the creditors’ agree-ment 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.

However, the preferred treatment granted to critical vendors clashed with the bankruptcy claims priority rules. They dic-tate that, as a general rule, claims should be paid based on where they stand on the claims priority ladder. Secured credi-tors are at the top of the priority ladder and are entitled to payment of the proceeds of their collateral. Creditors that

provide goods and services to a debtor in bankruptcy have administrative priority claims that are situated on the next lower rung of the priority ladder. Creditors at the next lower priority level include wage, salary, benefit and tax claimants. 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 credi-tors are paid in full.

Some courts had denied a debtor’s post-petition payment of critical vendors’ pre-petition unsecured claims because no Bankruptcy Code provision permits such payment and the payment violates the claims priority rules that require the full payment of higher priority claims prior to any payments to lower priority pre-petition unsecured creditors. Other courts have imposed onerous requirements as a condition for approving payment of such claims. 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 business 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 debtor realized economic gain, or avoided serious eco-nomic harm, that materially exceeded the amount of the pay-ment; and (3) the debtor had no practical or legal alternative to dealing with the vendor, except by paying its pre-petition unsecured claim. Bottom line, critical vendor relief would not be granted if there were other vendors willing to sell to the debtor on cash terms or other assurances of payment.

Then came the 2004 ruling of the United States Court of Appeals for the Seventh Circuit, in K-Mart, that the “necessity of payment” doctrine no longer applied under the Bankrupt-cy Code and a court could not rely on Bankruptcy Code Sec-tion 105(a) to approve a debtor’s payment of critical vendors’ pre-petition claims. The Seventh Circuit adopted a test, much like the test adopted by the Coserv court, that is very difficult to satisfy. Under the K-Mart test, a debtor seeking court approval of payment of a critical vendor’s pre-petition claim must prove that (a) the creditor would not do business with the debtor on any terms (even on cash terms) without the debtor’s payment of the creditor’s pre-petition claim, and (b) the non-participating creditors would be better off if the debtor paid the critical vendor’s pre-petition claim.

The Seventh Circuit’s harsh requirements for granting pre-ferred critical vendor treatment prompted some to pronounce the death knell of the critical vendor doctrine. However, the

The Seventh Circuit’s harsh requirements for granting preferred critical vendor treatment prompted

some to pronounce the death knell of the critical vendor doctrine.

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Seventh Circuit covers only the states of Illinois, Indiana and Wisconsin. It did not take long for bankruptcy courts else-where, particularly in Delaware, and the Southern District of New York, to approve a debtor’s payment of critical vendors’ pre-petition claims based on much less onerous requirements. However, that has not stopped other courts, like the Corner Home Care court, from severely limiting the availability of critical vendor relief.

The Corner Home Care decision denying Critical Vendor statusThe Corner Home Care court ruled that H.D. Smith was not entitled to critical vendor status and payment of its pre-peti-tion claim during the Chapter 11 case. Corner Home Care could not prove that (1) H.D. Smith was necessary for Corner Home Care’s successful reorganization; (2) Corner Home Care had exercised sound business judgment in seeking approval of payment of H.D. Smith’s pre-petition claim; and (3) Corner Home Care’s other unsecured creditors would not be prejudiced by the payment to H.D. Smith.

NecessityThe court noted that a creditor is necessary when there is no alternative to that vendor. A debtor can prove a creditor’s necessity by proving that either the creditor would not do business with the debtor on any terms or the unavailability of any other vendor to sell the same goods or provide the same services to the debtor.

Here, H.D. Smith was not necessary to Corner Home Care even though H.D. Smith had sold pharmaceutical goods and durable medical equipment to Corner Home Care at lower prices and on more favorable credit terms than other vendors were offering. First, H.D. Smith only refused to continue sell-ing to Corner Home Care based on current terms. Corner Home Care could not prove H.D. Smith’s unwillingness to continue selling to the debtor on cash terms or other appro-priate assurances of payment. Also, Corner Home Care could have always turned to AmerisourceBergen to purchase the same goods on cash terms.

Business JudgmentThe court also concluded that Corner Home Care did not exercise sound business judgment when it paid in excess of $140,000 of H.D. Smith’s pre-petition invoices during the Chapter 11. Corner Home Care showed poor business judg-ment in making the payments where H.D. Smith had not agreed to continue providing goods and services to Corner Home Care.

Prejudice to Other CreditorsFinally, Corner Home Care had failed to prove the absence of prejudice to other creditors from the favorable critical ven-dor treatment granted to H.D. Smith, particularly where AmerisourceBergen and other creditors had objected to such treatment.

Preference risk Faced by Critical VendorsA critical vendor remains subject to preference liability for payments the vendor had received within 90 days of bank-ruptcy that otherwise satisfy the requirements of a preference under Section 547(b) of the Bankruptcy Code.2 The courts have held that a critical vendor is not automatically shielded from preference liability unless the critical vendor order pro-vides for a waiver or release of preference claims. The courts are also divided over whether a critical vendor could take advantage of the new value defense to preference liability for pre-petition sales of goods and/or provisions of services that were paid post-petition under a critical vendor order.3

Some courts have ruled that a creditor can use its pre-petition invoices as new value, even when those invoices were paid post-petition pursuant to a critical vendor order. For exam-ple, the United States Bankruptcy Court for the Middle Dis-trict of Tennessee, in Phoenix Restaurant Group, Inc., allowed a creditor to include its pre-petition services, that were paid post-petition pursuant to critical vendor orders, as new value to reduce preference liability. The court concluded that the Section 547(c)(4) new value defense closes the preference window on the bankruptcy filing date. That limits a creditor’s new value defense to goods and/or services that were provid-ed pre-petition and subjects any new value to reduction only for pre-petition payments, not post-petition payments.

However other courts have refused to apply the Section 547(c)(4) new value defense to invoices that were paid post-petition. For example, the United States Bankruptcy Court for the Northern District of Illinois, in the Login Bros. Book Co. case did not count, as new value, invoices for goods that the Chap-ter 7 trustee had returned to the creditor post-petition pursu-ant to court order. The Login Bros. court and other courts concluded that creditors would obtain an improper windfall by receiving post-petition payment of their new value invoic-es and then using these invoices to reduce their preference liability. Creditors should receive a single benefit from their new value invoices—either payment of their claims or reduc-tion of their preference liability. These courts also concluded that the new value defense should not apply because the debt-or’s bankruptcy estate did not benefit from goods and/or ser-vices provided pre-petition that were subsequently paid for, or in the case of returned goods that were subsequently returned, post-petition.

ConclusionThe Corner Home Care case clearly demonstrates that not all bankruptcy courts are rubberstamping a debtor’s request to pay critical vendors’ pre-petition claims. The court made clear that a debtor seeking court approval of preferred critical ven-dor treatment had to satisfy a more difficult-to-prove three-part test. Corner Home Care’s failure to satisfy that test pre-cluded granting preferred critical vendor status in favor of H.D. Smith.

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The division among the courts over whether a creditor can include pre-petition invoices, that were paid post-petition pursuant to a critical vendor order, as new value to reduce preference liability also raises uncertainty about the utility of critical vendor status to creditors. This uncertainty could be ameliorated if the critical vendor order includes either a waiv-er or release of preference claims against the critical vendor or retention of the new value defense to preference liability for all invoices paid post-petition pursuant to the order. Alternative-ly, if the debtor and critical vendors are parties to an executory contract in existence when the bankruptcy was filed, the debt-or’s assumption of the contract during the bankruptcy case gives rise to a complete defense to any preference liability. ●

1. Section 549(a) of the Bankruptcy Code authorizes a trustee to avoid a debtor’s post-petition transfer of property of the estate that is not authorized by the Bankruptcy Code or the bankruptcy court. Section 550(a) of the Bankruptcy Code then allows the trustee to recover the improperly transferred property from, among others, the initial recipient of the transfer.

2. A preference is a (1) a debtor’s transfer of its property; (2) to or for a creditor’s benefit; (3) made on account of antecedent or existing indebtedness that the debtor owed the creditor; (4) within 90 days of the bankruptcy filing in the case of payments to non-insider trade creditors, and within one year of the filing for payments to insider creditors, such as a debtor’s officers, directors, controlling persons and certain affiliated companies; (5) when the debtor was insolvent, based on a balance sheet definition of insolvency (liabilities exceeding assets), which is presumed during the 90-day preference period; and (6) that enabled the creditor to obtain a greater recovery from the payment or other transfer than the creditor would have received in a Chapter 7 liquidation of the debtor in the absence of the payment

3. The Section 547(c)(4) new value defense to preference liability reduces a creditor’s preference liability to the extent the creditor had replenished the debtor and its bankruptcy estate by providing new goods and/or services on credit terms subsequent to the preference.

Bruce Nathan, Esq. is a partner in the New York City office of the law firm of Lowenstein Sandler PC. He is a member of NACM and is on the Board of Directors of the American Bankruptcy Institute and is a former co-chair of ABI’s Unsecured Trade Creditors Committee. He can be reached via email at bnathan@lowenstein.com.

*This is reprinted from Business Credit magazine, a publication of the National Association of Credit Management. This article may not be forwarded electronically or reproduced in any way without written permission from the Editor of Business Credit magazine.

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