ACritical Vendor Treatment?

No Sure Thing!Bruce NathaN, esq.

S e l e c t e d t o p i c

At long last, yet another court has issued a decision addressing a debtor’s motion to approve the payment of the pre-petition claims of alleged “critical vendors” during the debtor’s Chapter 11 case and prior to the approval of a Chapter 11 plan. This time, the United States Bankruptcy Court for the Northern District of Georgia, in In re News Publishing Company, denied a debtor’s motion to approve the payment of all but one of the pre-petition claims of these so-called “critical vendors.” The debtor could not satisfy the following stringent three-part test that the News Publishing court had laid down as a pre-condition for its approval of the critical vendor motion: (1) the necessity of the critical vendor payments for the debtor’s reorganization; (2) the critical vendors’ refusal to do business with and supply necessary goods and/or services to the debtor unless their pre-petition claims were paid; and (3) the lack of prejudice to other disfavored creditors by the critical vendor payments.

The takeaway from the News Publishing Company deci-sion is that critical vendor relief is no sure thing in many jurisdictions around the country.

BackgroundThe debtor, News Publishing Company, publishes one paid daily newspaper, five paid weekly newspapers, seven free newspapers, shoppers and niche publica-tions, and six newspaper and niche websites located in urban, suburban and rural markets. The debtor’s wholly owned subsidiary, Cherokee Publishers Company, also publishes one paid daily newspaper. The debtor also operates a substantial commercial printing business.

On January 1, 2013 (the petition date), the debtor filed its Chapter 11 case. At the inception of its Chapter 11, the debtor moved for authority to pay the pre-petition claims of 16 creditors the debtor had characterized as

“critical vendors.” These favored creditors fell within the following three groups: (1) supply companies that pro-vided supplies and equipment for the debtor’s printing press and related equipment; (2) service companies that maintained and repaired the debtor’s printing press; and (3) a temporary employment agency that provided temporary critical employees to the debtor.

The debtor argued that its non-payment of these criti-cal vendor claims would materially interfere with the debtor’s business operations. For instance, the debtor asserted that the “critical vendors” were the only rea-sonable alternative source of certain necessary goods and services. Unless the debtor paid their pre-petition claims, the “critical vendors” would likely either refuse to continue providing their goods and services to the debtor or provide them on unreasonable credit terms. The debtor’s estate and its other creditors would also benefit since the “critical vendors’” had to agree to con-tinue doing business with the debtor according to the trade terms in effect prior to the Chapter 11 filing date as a condition for receiving payment of their pre-peti-tion claims.

The debtor also justified the critical vendor payments because most of the vendors were entitled to adminis-trative priority status under Section 503(b)(9) of the Bankruptcy Code based on the debtor’s receipt of their goods within 20 days of the petition date. Finally, the debtor proposed to cap its total critical vendor pay-ments at not more than $200,000.

The debtor also submitted a supplemental declaration in support of its critical vendor motion. The supplemental declaration contained a chart that listed the 16 critical

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At the inception of its Chapter 11, the debtor moved for authority to pay the pre-petition claims of 16 creditors the debtor had characterized as “critical vendors.”

vendors, the nature and amount of their claims and the reason for critical vendor treatment. An abstract of the chart is pro-vided on page 15 (page 3 of this document).

One of the debtor’s largest unsecured creditors, United Com-munity Bank (UCB), with an unsecured claim totaling $885,988.86, objected to the debtor’s critical vendor motion. UCB argued that the debtor had failed to satisfy the stringent requirements for critical vendor relief that the United States Court of Appeals for the Seventh Circuit in the K-Mart case, and other courts had adopted. Specifically, the debtor did not prove that the “critical vendors” would not otherwise do busi-ness with the debtor during its Chapter 11 case, or the debtor’s Chapter 11 reorganization would fail and its unsecured credi-tors would receive nothing in the event the debtor had failed to pay the critical vendors’ pre-petition claims. Nor did the debtor submit any evidence of the pre-petition relationship between the debtor and the so-called “critical vendors” to show that the critical vendor payments were a continuation of the debtor’s ordinary course relationship with these creditors. Bottom line, the debtor was unjustifiably seeking payment of the unsecured claims of some inappropriately favored “critical vendors” while neglecting to pay other similarly situated unsecured claims, such as UCB’s claim.

the historical Grounds for critical Vendor treatmentPrior to the passage of the Bankruptcy Code, the courts had approved a debtor’s post-petition pre-plan payment of a cred-itor’s pre-petition claim based on the “necessity of payment” doctrine laid out by the United States Supreme Court in its 1882 decision in Miltenberger v. Logansport Railway. The Supreme Court had approved a debtor’s post-petition pre-plan payment of the pre-petition claims of those creditors who were found to be necessary for the reorganization and rehabilitation of the debtor’s business.

Following enactment of the Bankruptcy Code, the courts granted critical vendor relief based on the “necessity of pay-ment” doctrine and/or Bankruptcy Code Section 105(a). Sec-tion 105(a) recognizes the bankruptcy court’s equitable power to “issue any order, process or judgment that is necessary or appropriate to carry out the provisions of this title.”

Those courts usually conditioned granting critical vendor relief on the vendors’ agreement to continue extending post-petition credit to the debtor. The “critical vendors” benefitted through the elevation of their lower priority pre-petition gen-

eral unsecured claims to higher priority Chapter 11 adminis-trative priority claims with enhanced prospects for recovery.

However, the preferred treatment that “critical vendors” had enjoyed clashed with the bankruptcy claims priority rules. The priority rules required the payment of claims based on where they are situated on the claims priority ladder. Secured credi-tors sit at the top of the priority ladder and are entitled to pay-ment of the proceeds of their collateral. Creditors providing goods and services to a debtor in bankruptcy have administra-tive priority claims that sit on the next lower rung of the prior-ity ladder. Creditors at the next lower priority level include wage, salary, benefit and tax claimants. Pre-petition general unsecured claims occupy the lowest creditor rung of the prior-ity ladder and are not entitled to receive any distribution from the debtor until the higher priority creditors are paid in full.

While some courts had granted a debtor’s motion to approve critical vendor treatment with virtually no analysis, other courts subjected a debtor’s critical vendor motion to far more scrutiny. Some courts denied a debtor’s post-petition pre-plan payment of critical vendors’ pre-petition unsecured claims based on the absence of any Bankruptcy Code provision per-mitting such payment and the violation of the claims priority rules that did not permit the payment of lower priority pre-petition unsecured creditors prior to the payment of higher priority claims.

Other courts imposed stringent requirements as a condition for approving the payment of critical vendor claims. For instance, the United States Bankruptcy Court for the North-ern District of Texas, in In re Coserv, L.L.C., conditioned a debtor’s payment of critical vendors’ pre-petition claims on the debtor’s proof that (1) the vendor was indispensable to the debtor’s business because the vendor was a major cus-tomer of the debtor, the sole supplier of a particular product the debtor needed, or controlled a valuable property the debtor needed; (2) the debtor would realize economic gain, or avoid serious economic harm, that materially exceeded the amount of the payment, and (3) the debtor had no practi-cal or legal alternative to dealing with the vendor, except by paying the vendor’s 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.

The United States Court of Appeals for the Seventh Circuit, in its watershed 2004 K-Mart ruling, rejected the debtor’s request to pay the pre-petition unsecured claims asserted by 2,330 of its trade creditors, in the aggregate amount of approximately $300 million. The Seventh Circuit had held that the “necessity

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it did not take long for bankruptcy courts outside of the seventh Circuit to approve a debtor’s payment of critical vendors’ pre-petition claims based on much less onerous requirements.

Other courts imposed stringent requirements as a condition for approving the payment of critical vendor claims.

Vendor Product/Service Total Due Reason Vendor is Critical

Camp Industries

Supplies $7,452.34 Camp provides us with paper towels, toilet paper, stretch wrap for pallets. Trash bags, strapping for our newspaper bundles, copy paper and the like from a local warehouse with same-day service, at prices very competitive with the large office supply stores and better than other local supply houses. Camp shipment schedule provides “just in time” delivery, saving us money by avoiding the need to stock inventory and the employee time wasted on driving to purchase products for the day-to-day operation.

Cleveland Electric Company

Electrical repairs for press and mailroom

$533.64 Cleveland is the only provider in the area that has electricians who have experience with newspaper presses and newspaper inserting equipment. They can troubleshoot electrical problems 24 hours a day, 7 days a week in a very timely manner due to their experience working on this type of equipment. They understand our strict time deadlines and know we must meet printing deadlines. They know our equipment and get us back up and running faster than a company without all of their expertise.

Culligan Water Company

Water system pressroom/plate room

$1.984.33 Culligan is the only provider in the area that has experience with newspaper equipment, knows our pressroom and has extensive knowledge of our water requirements for printing. Replacing this vendor with one who does not know the Debtor’s equipment could risk damage to the Debtor’s equipment and business.

Employment Innovations, Inc.

Employment agency mailroom and dock workers

$72,151.14 This employee leasing agency provides us with our experienced delivery drivers and dock workers who distribute all of the papers to the various delivery people. Quite simply, the workers provided by this agency are, in reality, long-term valued workers of the Debtor. Without these experienced workers, the Debtor would not be able to deliver its products. These workers are provided by this vendor because of the vendor’s superior workers compensation experience rating at better rates than would be available to the Debtor with employees hired by the Debtor. Further, such employees would, in all likelihood, drive up the Debtor’s workers compensation experience modification rate for its other workers with the attendant increase in costs. This vendor can also provide the Debtor with emergency workers if we have an inserting machine failure and are required to insert manually, thus allowing us to make our deadlines.

Image Electric

Electrical repairs for press/mailroom

$5,803.92 Image Electric provides on call electrical service 24 hours a day, 7 days a week for our interior and exterior building electrical inside and out. Image Electric provides on-site service in less than 45 minutes. Their knowledge of the electrical, systems in our building has saved, and will continue to save us valuable time and their prompt emergency service is critical during production hours. Several other local electricians have not been able to provide us with the time-sensitive service we need to meet our deadlines.

Manugraph DGM, Inc.

Parts for press

$2,096.87 This is the manufacturer of our press and they provide us with parts and service. We have used other companies for parts and have always gone back to DGM because other vendors could not provide us the parts we needed. Without this company, it would be difficult to maintain the press and, thus, our entire business operation.

Masterflo Technology, Inc.

Parts for press water system

$248.36 This company supplies the water system on the Debtor’s printing press that mixes and chills the water and fountain solution, and provides parts and service to that system. The Debtor is not aware of any other company that can provide parts or service to this water system. Without the proper water mixture, we could not print.

Quadtech Cameras on the press

$5,011.00 This company provides the camera system for the registration on the press, which reduces costs by having less waste. This saves us expense in excess waste and wages, as less time and paper is used to produce quality product more quickly. This is the only company that provides support and parts for this system.

RBP Chemical

Chemicals for press

$1,723.43 This company supplies the fountain solution, tape for changing newsprint rolls and lead tape for fixing web breaks. This company is the supplier for fountain solution recommended by the plate manufacturer to correct our previous problems with plate cleaning during the printing process and has solved the production issues we were previously experiencing.

Ryder Transport. Services

Fuel and Service/ Repair of fleet

$9,115 32 Fuels and truck repairs to leased fleet. This vendor provides the trucks that we lease and rent to deliver all of our products. Ryder also provides us with fueling and repair service 24 hours a day, 7 days a week. If a truck breaks down, they will fix it or get us another one right away. They have two fueling stations in our area. They can also provide us with an extra rental truck when we have holidays, all of which are critical to our delivery operation.

Southern Lithoplate

Plates for the press

$61,011.16 Southern Lithoplate provides plates for the printing press and is one of only two available plate suppliers in this market. Southern Lithoplate recently installed a plate processor on our printing press and their plate is $1.00 cheaper than competitor Kodak’s plate resulting in savings of approximately $5000 per month compared to our prior vendor.

Pierre Rene Noth

Regular Columnist

$384.52 Columnist provides regular content for our publications.

Mark Green Stringer $100.00 Stringer provides coverage in the way of columns, stories, photos and video when events/incidents outnumber reporters.

Randy L. Jones

Stringer $200.00 Stringer provides coverage in the way of columns, stories, photos and video when events/incidents outnumber reporters.

Robert V. Ozment

Regular Columnist

$50.00 Columnist provides regular content for our publications.

Tonya Cook Stringer $50.00 Stringer provides coverage in the way of columns, stories, photos and video when events/incidents outnumber reporters.

support for critical Vendor status

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of payment” doctrine no longer applied under the Bankruptcy Code and the bankruptcy court’s equitable power under Bankruptcy Code Section 105(a) was not an appropriate basis for approving a debtor’s payment of critical vendors’ pre-peti-tion claims. The Seventh Circuit adopted a harsh test that many other courts, like the News Publishing court, later fol-lowed with their own spin. Under the K-Mart test, a debtor seeking court approval of its post-petition pre-plan payment of a critical vendor’s pre-petition claim had to 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-participat-ing 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 many prognostica-tors to ring in the death knell of the critical vendor doctrine. However, it did not take long for bankruptcy courts outside of the Seventh Circuit (Illinois, Indiana and Wisconsin), partic-ularly 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. That has not stopped other courts from severely limiting the availabil-ity of critical vendor relief.

For example, the United States Bankruptcy Court for the Western District of Kentucky, in Corner Home Care, had ruled that an unsecured creditor was not entitled to critical vendor status and payment of its pre-petition claim during the debtor’s Chapter 11 case. The court determined that the debtor could not satisfy an equally stringent three-part test (much like the K-Mart test) for obtaining critical vendor relief: (1) the creditor was necessary for Corner Home Care’s successful reorganization; (2) the debtor had exercised sound business judgment in seeking approval of payment of the creditor’s pre-petition claim; and (3) the debtor’s other unse-cured creditors would not be prejudiced by the payment to the so-called critical vendor.

the News Publishing court’s refusal to approve Payment of Most critical Vendor claimsThe News Publishing court denied the payment of the claims of all but one of the alleged “critical vendors.” The court pretty much followed the K-Mart decision and ruled that a debtor seeking approval of critical vendor payments had to prove all

of the following: (1) the necessity of the payments for the debtor’s reorganization; (2) the critical vendors’ refusal to do business with the debtor and supply necessary goods and ser-vices if they did not receive payment of their pre-petition claims; and (3) the lack of any prejudice to other creditors arising out of the critical vendor order (i.e., creditors not enjoying critical vendor relief would be as well off with the critical vendor order as they would have been without it).

The court applied this test to each of the debtor’s “critical ven-dors.” The court refused to approve the payment of the pre-petition claims of 14 “critical vendors,” (not including Etowah Employment Innovations and Southern Lithoplate) because they were merely beneficial, important or preferred. The debt-or could not prove that any of these vendors was critical to the debtor’s business and reorganization prospects.

There was also no mention in the debtor’s supplemental dec-laration that any of these 14 vendors would refuse to do busi-ness with the debtor, even on cash terms, if their pre-petition claims were not paid during the debtor’s Chapter 11 case. The supplemental declaration also failed to state that the proposed “critical vendor” payments were necessary for the debtor’s reorganization. The court was also not persuaded that seven of the vendors, who were owed nominal amounts of $553.64 or less, would refuse to continue to do business with the debt-or even on cash on delivery or cash in advance terms.

The court also rejected the testimony of the debtor’s president, Burgett H. Mooney, III, that the debtor and/or Mr. Mooney had reached out to all 14 creditors and that “some” had stated their unwillingness to do business with the debtor in the event the debtor had failed to pay their pre-petition claims. The court found Mooney’s statement to be vague, generalized and unsubstantiated by any other evidence that the debtor had presented at the hearing.

The court then addressed Southern Lithoplate’s so-called “critical vendor” pre-petition unsecured claim in the amount of $61,011.16, the second largest pre-petition claim among the designated “critical vendors.” Southern Lithoplate had supplied the debtor with certain plates specific to machinery Southern Lithoplate had supplied to the debtor. Southern Lithoplate was supposedly a “critical vendor” because the debtor alleged that it could not use this machinery if it had switched to an alternate plate supplier.

The court rejected Southern Lithoplate’s “critical vendor” sta-tus because an alternative supplier, Kodak, was available to supply the same printing plates at a lower cost to the debtor. The court also warned Southern Lithoplate that it would vio-late the automatic stay and be subject to sanctions if it had stopped doing business with the debtor because of the debt-or’s failure to pay Southern Lithoplate’s pre-petition unse-cured claim.

The court finally addressed Etowah’s claim in the amount of approximately $77,000, the largest pre-petition claim among

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the court’s holding in the news Publishing case clearly demonstrates that not all bankruptcy courts are rubberstamping a debtor’s request to pay the pre-petition claims of so-called “critical vendors.”

the designated “critical vendors.” Etowah, as a staffing com-pany, had provided workers to the debtor who had performed a range of jobs, including delivery and dock workers and mail order workers. Layton Roberts, Etowah’s president, had testi-fied at the hearing on the critical vendor motion that Etowah was the debtor’s staffing agency of choice because Etowah had provided specialized newspaper and seasonal workers to the debtor at the lowest possible cost.

Roberts’ testimony did not satisfy the court that the payment of Etowah’s pre-petition claim was necessary for the debtor’s reorganization. The debtor could always use an alternative staffing agency to provide employees, or rehire its former workers then employed by Etowah. The court also questioned Roberts’ credibility when he stated that Etowah would have gone out of business if its pre-petition claim were not paid. He contradicted this statement in his later testimony that Etowah’s business with the debtor amounted to only 10% of Etowah’s revenues, Etowah had 40 to 50 other clients, and Etowah had factored the invoices owing by the debtor and, therefore, already received payment of a portion of its claim.

However the court approved the payment of $50,000 of Etowah’s claim, the portion owing to the employees Etowah had supplied to the debtor. The court considered these employ-ees to be functional equivalent of the debtor’s employees. As such, their pre-petition claims were entitled to special priority treatment under Section 507(a)(4) of the Bankruptcy Code that entitled them to full payment before any payments could be made to the debtor’s lower priority pre-petition general unsecured claims, such as UCB. As a result, the debtor’s other creditors (such as UCB) were not prejudiced by the debtor’s expedited payment of the portion of Etowah’s claim attributed to the employees Etowah had provided to the debtor.

conclusionThe court’s holding in the News Publishing case clearly dem-onstrates that not all bankruptcy courts are rubberstamping a debtor’s request to pay the pre-petition claims of so-called “critical vendors.” The court reaffirmed that a debtor must satisfy the stringent requirements that the United States Sev-enth Circuit Court of Appeals in K-Mart and other courts consider as a prerequisite for obtaining court approval of a debtor’s payment of certain favored vendors’ pre-petition unsecured claims. So debtors be warned: not all courts are willing to rubberstamp their critical vendor motions!

Bruce S. Nathan, Esq. is a partner in the New York City office of the law firm of Lowenstein Sandler LLP. He is a member of NACM and is a former member of the Board of Directors of the American Bankruptcy Institute and is a former co-chair of ABI’s Unsecured Trade Creditors Committee. Bruce is also the co-chair of the Avoiding Powers Advisory Committee working with ABI’s commission to study the reform of Chapter 11. 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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