Will I get paid if I keep supplying a company in Chapter 11 bankruptcy?

As long as a company is in the possession of a bankruptcy court, vendors and landlords usually feel safe. With all the protections in the Bankruptcy Code and the first-day orders issued from the bench, they assume the debtor is being forced to address their needs. That is true, but only to a point, and that point is worth remembering.

Companies in bankruptcy often string you along with promises to pay for anything delivered after they file for protection. But that hope often ends up with your name on the list of unpaid creditors.

The recent Chapter 11 filing by Big Lots is an important reminder that it always pays to be careful when you deal with a debtor.

A High Level of Comfort for Creditors and Landlords

The U.S. Bankruptcy Code provides a high level of comfort for creditors and landlords of a debtor company in Chapter 11, at least at first blush. To protect creditors, the Bankruptcy Code imposes a set of requirements on debtors. Under Section 365(d)(3) of the Code, for example, the debtor must continue to perform their post-filing obligations until it assumes or rejects the lease, including any obligation to pay rent for space they occupy.

Unpaid post-filing rent constitutes a priority administrative claim, which is a type of unsecured claim that must be paid in full before anything is paid to ordinary unsecured creditors. The usual assumption is that rent will be paid.

Landlords get a unique protection in one particular setting. A shopping center tenant must cure all defaults before it can assume or assign the lease. The debtor must also give ‘adequate assurance of future performance.’

To assure a landlord that their position will not deteriorate, and that they will receive the benefit of their bargain under a lease, the phrase adequate assurance of future performance has a very specific meaning in bankruptcy. In the case of a qualifying shopping center lease, it requires a debtor to demonstrate that the center itself will not lose value as a result of the assumption of the lease.

The court asks, for example, whether the assignee of the lease has a similar financial condition and operating performance. Percentage rent will not fall substantially. Other lease terms remain binding, including any exclusive use clauses. The court takes special care to ensure that the mix of tenants does not change.

The filing of a bankruptcy petition under Chapter 11 affords an added layer of protection to post-bankruptcy vendors of goods. These are the suppliers who sell to the debtor after the case is filed. Unpaid, post-petition claims, called administrative claims, arise when a debtor continues to purchase goods or services during the administration of the bankruptcy case. They are generally entitled to priority payment. Section 503(b)(9) provides that for goods supplied to the debtor within the 20 days prior to the case being filed, the vendor receives an administrative expense claim as well.

With the court’s approval, the debtor often forms special procedures for purchasing items that are critical to the success of the debtor. These suppliers are called critical vendors, and the deals that establish their status are called critical vendor orders or first-day orders. The doctrine of necessity allows the debtor to pay their pre-filing claims, too, to keep the business operating as a going concern.

Finally, to confirm a plan of reorganization in Chapter 11, a debtor must pay in full all administrative claims. A landlord or vendor who has dealt with the debtor post-filing, therefore, often feels safe because the business must pay them or fail.

Big Lots is the most recent reminder that your confidence is misplaced. Its case shows that you cannot be assured that the debtor will pay your bills.

Right after filing, Big Lots made sure to deliver an immediate message to vendors and landlords who feared they might not get paid. To get debtor-in-possession financing, the company told the court that its budget for the case covered the payment of what is called stub rent. It even adopted a critical vendor program to honor unpaid pre-filing claims in exchange for continued open credit.

Nexus Capital Partners was the firm Big Lots tapped to buy its operating business and more than 800 stores. Big Lots seemed very certain that the company would be able to continue as a going concern. It was enough to get vendors and landlords to cooperate.

Nexus needed Big Lots to replenish its stores to a set inventory value. Big Lots needed to get those supplies to the stores, and that demanded a significant investment. It was the vendors, who assumed all of the risk in the exchange. Big Lots placed more than $215 million in orders for goods and supplies on post-filing trade credit. The dollars started to pile up. Separately, suppliers held 503(b)(9) claims of $38 million for goods delivered in the 20 days before filing, and landlords had post-filing claims too. In all, their combined exposure was more than $250 million.

Nexus was unwilling to consummate the sale because the inventory level was less than they required. That left Big Lots stuck with a problem: a fire-sale liquidation and an administratively insolvent estate. It did not have the financing to pay vendors, and it had far less value than a going concern, if any at all.

Luckily, a last-minute deal to sell to Gordon Brothers Retail Properties saved 200 to 400 stores. The deal solved the problem for Big Lots, but not its vendors and landlords.

The GBRP deal ensured payment to certain categories of administrative claimants, including professionals, some landlords and vendors who supply goods from now on, but not post-filing debts already owed. Vendors and landlords were left to fight for the scraps. After being encouraged to extend credit and supply goods, they were left in limbo. The deal created two classes of creditors, the lucky and the unlucky.

Big Lots’ proposed wind-down budget explicitly provided for a $13,438,000 increase in the professional fee reserve for two more months of work. The deal also gives certain landlords $17 million for unpaid administrative rent. What was left over was far less than enough to pay the unlucky, who hold roughly $250 million in post-petition claims.

This leaves the unlucky with roughly $19 million kept out of the GBRP sale: anticipated tax refunds and litigation recoveries, plus a share of real estate sale proceeds. That may sound like a large pool for administrative claimants, but it is only a small piece of the claims, and the dividend will be small.

The landlords and vendors argued that the GBRP sale violated the Bankruptcy Code’s priority scheme. They asked that the sale proceeds be held in escrow, with distribution and priority sorted out after closing. The court rejected all of those arguments and approved the deal on GBRP’s terms.

As a supplier or landlord, you get used to the idea that you will get paid as the case moves along.

You cannot rely on all of the protections in the Bankruptcy Code. They only protect you to a point, and you cannot assume that the company will continue as a going concern. You need to look for the rights to protect your position. Be wary when a company asks you to extend post-filing credit.