Critical Vendors in a Retail Bankruptcy – Part I

In a Chapter 11 bankruptcy proceeding, the courts have allowed a bankrupt retailer to repay amounts owed to suppliers deemed “critical” early on in the bankruptcy process.  This is a substantial benefit provided to a select group of suppliers that are essential to the survival and success of the ongoing business.

Under the Bankruptcy Code, pre-petition claims cannot be paid by the Debtor without a plan of reorganization or court order.  Since the Bankruptcy Code provides a specified-priority order for the payment of debts existing at the filing date (“the absolute priority rule”), unsecured creditors generally are not paid anything until all secured, administrative, and priority creditors are paid in full.  Unsecured creditors must wait in line to be paid on the debts that existed at the time the Debtor filed for bankruptcy.  These creditors may end up waiting for years to receive payment, if they get anything at all, while creditors deemed “critical” or “essential” may move up to the front of the line and can be paid ahead of the other unsecured creditors during the bankruptcy proceedings.

Retailers sometimes need the ability to pay true “critical vendors” since some suppliers may refuse to do business with the retailer after it files for bankruptcy.  If the supplier is truly “critical” to the business, the “critical vendor’s” refusal to ship could harm the retailer’s operations and threaten its survival.  As such, the rationale for allowing a retailer to make payments to “critical vendors” is that these payments actually ultimately benefit all unsecured creditors.

Whether a vendor is “critical” depends on its impact to the retailer.  The vendor must be deemed absolutely necessary for the success of the retailer to be considered a “critical vendor.”  A vendor is not deemed critical simply because it won’t ship products to the Debtor.  Generally, the Bankruptcy Court must be convinced that there is no alternative source of supply at a reasonably similar price for the goods or services provided.

Over the years, many retailers have become more aggressive in seeking approval of a greater number of suppliers as “critical vendors.”  For example, in 2004, Kmart sought approval of a critical vendor motion for the payment of up to $300 million to more than 2,300 “critical vendors.”  Although the Bankruptcy Court approved Kmart’s motion, the 7th Circuit Court later overturned the Bankruptcy Court.  Since the ruling, critical vendor treatment has been more difficult to achieve.

In Part II of this blog, we will discuss the stringent test the Bankruptcy Courts are using post-Kmart to determine when a vendor is truly “critical” as well as examples of recent critical vendor motions in retail bankruptcy cases.