One client asked me this question: “If I file chapter 11, can I keep my doors open?” Yes, and in fact you’re supposed to, because chapter 11 is a workout procedure and the companies that file for it are hopefully going to stay in business. The tricky part is keeping people shipping to you while you’re not paying them.
The point of chapter 11 is to create the time it takes to write up a reorganization plan, a plan that’s fair to your creditors. To do that, the business has to keep running. If it doesn’t, it won’t be worth anything to anyone. But if you’re at the point of filing, don’t expect your suppliers to just keep rolling in their trucks. You probably owe them money, they’ve heard about your financial troubles, and many businesses in bankruptcy can’t keep their doors open because their vendors decide not to give them any more goods or services. If you run a restaurant and don’t have any ingredients in your kitchen, you’re not going to be able to serve customers.
Critical Vendor Motion
But what if one of your big suppliers says it won’t deliver anything unless you pay its prepetition bill? That’s when a business files a critical vendor motion, usually as part of its first-day motions. It asks the judge to approve it paying some old bills of a vendor or vendor group deemed critical to the company’s operations. The legal theory is the “doctrine of necessity“. It is now customary to file one along with your first day request for DIP financing. If the judge denies it, the business can’t keep operating, creditors recover even less, and a reorganization may not be feasible. In that case, the case might be converted to a chapter 7, to sell the company’s assets.
A critical vendor is one with whom you have an important relationship, integral to your day-to-day operations. Maybe their product is special, and you don’t have a substitute on hand. Maybe you’ve had a long-standing relationship that the vendor has customized in all sorts of ways, so even if you don’t like them right now, it will take you a while to figure out how to work with another vendor, and you don’t have that time. Or maybe they’ve already told you they won’t do business with you anymore because of the unpaid bills. For example, without laundry machines, the laundry services company can’t operate; without electricity, the tavern can’t stay open; without sugar, the company that makes candy bars will not be able to produce product to sell.
It’s good to remember that only some vendors are granted “critical vendor” status. They are key suppliers, usually the ones that you’ve owed money to for some time, and whose supply you could not survive without. Usually the ones that have a pretty large balance that grew over months and years, and especially in the time leading up to the filing. A relationship that long usually means a long-term contract, and a vendor like that may still threaten to walk. That doesn’t mean they have the right to cut you off, though; that’s a matter for the contract, which you need to review case by case.
Why Would the Vendor Agree
Why would the vendor agree? Normally an old bill just becomes a general unsecured claim, and those typically recover very little. With a critical vendor order, the claim becomes an administrative expense, which means it has to be paid in full for the plan to be confirmed. And separately, anything the company takes delivery of within twenty days of the filing also gets administrative priority. Everyone else stays general unsecured. The vendor is better off than before. If your reorganization fails and the business is liquidated, critical vendor claims are given administrative expense status. Maybe the debtor is insolvent and the claim won’t be paid in full, but it’s still in a better position than a general unsecured claim.
The payment comes with strings, though. Once it signs a critical vendor agreement, the vendor has to keep supplying you and honor whatever terms are in it. Don’t expect a windfall: you don’t get special discounts or anything, but the contract does protect you against the vendor making any supply terms worse than what you had before. If the vendor takes the money and then stops shipping, the critical vendor payment can be clawed back, and you can sue the vendor for breach of contract for failing to perform under the critical vendor agreement.
Not Everyone Likes This
Not everyone likes this. Critics argue that, whatever the legal theory, these payments cut against two fundamental principles of bankruptcy: the absolute priority rule and the equal treatment of creditors within a class. The complaint seems to be mostly that these things are approved so easily and so often, and that the payments seem to be going to vendors who weren’t really essential. What, exactly, is “critical,” though? At a certain point, doesn’t it become arbitrary, a little bit of favoritism? It all depends, as usual, on the jurisdiction and the judge.
In 2002, Kmart entered Chapter 11. Shortly after, they asked for permission to pay prepetition obligations of critical vendors. The court went along, because Kmart argued that it needed the products that critical vendors supplied (like, say, groceries) to stay in business. Well, Kmart had something like 2,000 other vendors and some 43,000 unsecured creditors left unpaid. All those vendors could have been called “critical” under the same logic. Kmart was about to get its plan confirmed and close its Chapter 11 exit when the order allowing the payments was reversed, even though Kmart had already made them.
Kmart appealed, and in 2004 the Seventh Circuit Court of Appeals affirmed the reversal, rejecting the preferred treatment of about 2,300 critical vendors whose prepetition claims topped $300 million. It said the bankruptcy court could not rely on the so-called “necessity of payment” doctrine or on its equitable powers under Section 105(a). The debtor must prove, the court said, that the vendors would not deal on any terms if not paid, that without payment the debtor would be forced to liquidate and that any liquidation distribution to unsecured creditors would be less than what they would receive under the plan.
Kmart couldn’t prove that a bunch of vendors would stop delivering, and as it turned out, many of the vendors still had long-term contracts. It also couldn’t show that the disfavored creditors were better off. Most of them would have received about 10 cents on the dollar or less. The bottom line is that the burden is on the debtor. As a result, the Seventh Circuit tightened its approach after this case, and other circuits remain easygoing. It’s an issue that’s still pretty controversial.
So, can you keep operating during Chapter 11? The answer is: of course you can. The law assumes you are going to. The question is whether your key vendors and distributors keep shipping. The critical vendor motion is the main tool for that. This is an extremely routine motion, but it has to be justified — the vendor has to be critical — and how the judge looks at the “critical” part of that depends where you are. Either way, you need to be able to show that the vendor is truly critical, and some judges will be pretty tough.
