Client Alert

When a customer files for relief under chapter 11, vendors are typically hit with an open account balance that becomes a general unsecured claim and is not allowed or paid until the end of the case. Further, vendors usually receive only pennies on the dollar for those claims. Adding insult to injury, vendors are often forced to disgorge preferential payments that they received pre-petition (i.e., before the chapter 11 petition is filed). It is not surprising, then, that vendors commonly react to customers who file chapter 11 by suspending further sales, at least until they have some reasonable assurance of being paid for post-petition (i.e., after the chapter 11 petition is filed) sales. For some vendors, the decision on whether and how to sell post-petition depends on the terms of an executory contract with the customer. For others, the suspension in doing business becomes permanent. Still others resume selling, but only on a COD, CBD, or other no-risk basis. This alert advises our vendor clients about their payment priority rights for post-petition credit sales to a customer, for pre-petition credit sales of goods received by the customer within 20 days prior to its chapter 11 filing, for pre-petition credit sales of goods received by the customer within 45 days prior to its chapter 11 filing, and for pre-petition and post-petition credit sales if the vendors qualify for and are paid as critical vendors in the customer’s chapter 11 case.

Payment Priority for Post-petition Credit Sales
Shortly after filing for chapter 11, customers normally contact the vendors they wish to continue doing business with, urging that they resume selling on open credit. The customers will point out that the Bankruptcy Code treats their purchases of goods and services post-petition as an administrative expense of the bankruptcy estate and that administrative expenses are entitled to a payment priority over all pre-petition unsecured debt and certain other lower level priorities. They will also point that invoices for post-petition sales will be paid in the ordinary course of business and will not have to wait until a chapter 11 plan is confirmed. Finally, customers seeking post-petition trade credit will often trumpet the fact that they have obtained post-petition financing of X dollars and therefore will arguably have the cash needed to pay vendors for post-petition credit sales.

Without question, the Bankruptcy Code’s payment priority for administrative expenses is an important consideration in deciding whether to sell on credit to a chapter 11 customer. However, vendors should examine in each case whether the customer’s bankruptcy estate has sufficient assets to pay all of its administrative expenses. The fact that a case has post-petition financing is a positive indicator of funds being available to pay for goods and services, but there are a number of chapter 11 cases which had post-petition financing and later turned out to be “administratively insolvent” (i.e., not enough money to pay all administrative expenses). The creditworthiness of a chapter 11 estate can change rapidly – what once was a promising candidate to reorganize can quickly become a lock to liquidate. The point here is that a chapter 11 customer’s financial strength is dynamic and must constantly be reassessed.

In every customer’s chapter 11 case, there will be filings with the court that offer insight into the estate’s financial health, including but not limited to the declaration or affidavit of the customer’s chief financial officer or other officer supporting the first day motions, the post-petition financing order, motion and credit agreement, the debtor’s monthly operating reports, schedules of assets and liabilities, and statement of financial affairs, the first meeting of creditors, and various motions and objections filed by creditors and other parties in interest. Because of electronic filing, the use of claims agents for larger cases, and the online search capability of Pacer, access to this pleading information is immediate and nationwide. Vendors and their counsel should regularly review and interpret this data, not only in making the initial decision on whether to sell on credit post-petition, but also in deciding whether and when to cease such sales because of a material change in the estate’s financial health causing or threatening administrative insolvency.

Payment Priority for Pre-petition Credit Sales of Goods Received by Customer During 20 Days Prior to Chapter 11 Filing
In 2005, the Bankruptcy Code was amended to provide a substantial new right of recovery for creditors who are vendors of goods. Under sections 503(b)(9) and 507(a)(2) of the Bankruptcy Code, priority in payment ahead of general unsecured claims is granted for the “value of any goods received by the debtor within 20 days before the commencement of a [bankruptcy case] in which the goods have been sold to the debtor in the ordinary course of the debtor’s business.” Although invoices for goods sold post-petition on credit are usually paid in the ordinary course of business, invoices for goods sold pre-petition and received by the customer during the 20 days prior to the chapter 11 filing (the “20-Day Period”) are not likely to be paid until the end of the case. Moreover, vendors must file requests for payment or proofs of claim for the value of goods they contend were sold on credit and received by the customer in the ordinary course of its business during the 20-Day Period. The payment requests and proofs of claim will have to be supported by appropriate documentation and may require discovery and an evidentiary hearing. Vendors of services do not qualify for this payment priority.

Possible Payment Priority for Reclaimed Goods
The 2005 amendments to section 546(c) of the Bankruptcy Code also affected vendors’ reclamation rights. At first blush, the amendments seem favorable to vendors in that the reclamation period was expanded from 10 days to 45 days (the “45-Day Period”). However, the clear right either to recover the goods or receive a payment priority for their value was eliminated, and in most jurisdictions vendors face other substantial legal and factual impediments to proving their reclamation claims. As a practical matter, the pre-petition payment priority for goods received within the 20-Day Period appears to have supplanted any payment priority for goods received within the 45-Day Period for which the vendor has demanded and is entitled to reclamation. Vendors are urged to continue making timely reclamation demands and then assessing in each particular case whether it makes economic sense to prosecute a reclamation claim.

Payment Priority for Pre-petition and Post-petition Credit Sales as a Critical Vendor
In some jurisdictions, including Delaware where many of the largest chapter 11 cases are filed, a key consideration for vendors of both goods and services is whether the customer has moved for and obtained a court order to pay the pre-petition unsecured claims of its “critical” vendors. If the bankruptcy court enters a critical vendor order, it will generally authorize – but not require – the customer to spend up to Y dollars in paying critical vendors. Court filings rarely identify critical vendors by name, but they do usually describe categories of critical vendors with sufficient specificity that a vendor can determine whether it is included. Vendors should not make the mistake of resuming post-petition credit sales without first determining if they can condition such sales on being treated and paid as a critical vendor. Vendors need to be aware that to qualify for and receive a critical vendor payment, they will have to agree to certain terms and conditions of doing business post-petition, including the extension of credit. The critical vendor motion and order will specify some of those terms, and the customer will likely have a standard form of critical vendor agreement that it will propose be signed. However, before signing, vendors should know that some of the proposed critical vendor terms are likely to be onerous. The good news is that such terms are often subject to negotiation. Success in those negotiations will likely turn on whether the vendor and customer are ably represented and how important the vendor’s goods or services are to the customer’s business. Finally, because a critical vendor motion is usually filed at the beginning of the case, the customer does not have to move for a critical vendor order, and the customer’s lender may have to consent to paying critical vendors, vendors are advised to raise the critical vendor issue with their customers at the earliest opportunity and, where circumstances permit, even prior to the chapter 11 filing.

Treatment as a critical vendor can affect a vendor’s payment priority rights for (i) post-petition credit sales, (ii) pre-petition credit sales of goods received within the 20-Day Period, and (iii) pre-petition credit sales of goods received within the 45-Day Period for which a reclamation demand has or can be made. An example is the treatment of critical vendors in the jointly administered chapter 11 cases of Smurfit-Stone Container Corporation and affiliates (the “Debtors”) in Delaware. By order entered January 26, 2009, the Debtors are authorized to use up to $50 million to pay the pre-petition claims of critical vendors. The order provides that “unless otherwise agreed to by the Debtors, in their sole discretion,” any payment of a critical vendor’s pre-petition claim will be applied first to its claim for goods received within the 20-Day Period, that the critical vendor will not separately assert or otherwise seek payment of any reclamation claims, and that if the Debtors terminate a critical vendor agreement or a critical vendor ceases to supply goods post-petition in breach of the critical vendor agreement, the Debtors may unilaterally apply the critical vendor payments to the account balance owed for goods purchased post-petition. Some of these terms vendors should try to negotiate before signing a critical vendor agreement.

With the rash of recent chapter 11 filings and those anticipated in the coming months, vendors are well advised to understand and pursue their payment priority rights. For more information, contact William B. Sullivan at 336-721-3506 or wsullivan@wcsr.com.