Bankruptcy Court Finds “Critical Vendor” Label Provides No Insulation from Preference Claims

In what could likely end up an influential ruling, a Delaware court recently held that securing a “critical vendor” status in Chapter 11 commercial bankruptcy case ultimately offers no defense in situations where the vendor later faces legal action for the recovery of preferential payments that the debtor recoups shortly before bankruptcy.

The Role of “Critical Vendor” Status

In a large number of Chapter 11 cases, the party who pursues bankruptcy has received inventory from suppliers deemed critical in the operation of a business and to reorganization efforts. These suppliers are under no obligation to continue doing business with debtors while in bankruptcy. Suppliers also have no duty to keep debtors on credit terms that conform to those that were previously used.

Many bankruptcy courts permit a debtor to establish critical vendor classifications where the debtor selects what it considers “critical vendors” whose claims before the debtor files for bankruptcy will be paid entirely in exchange for a commitment to sell goods on credit during reorganization. The thinking behind these programs is that they permit debtors to hold on to “critical vendor” status during reorganization and increase the odds of successfully leaving Chapter 11. To qualify as a “critical vendor,” a creditor must provide an item or skill that the debtor would have a difficult time obtaining anywhere else. Programs of this nature are often pursued early in cases. If a creditor does not receive “critical vendor” status, the vendor might still be able to argue in favor of such a designation or test the nature of what it supplies by declining to continue doing business with the debtor with the goal of being labeled as a “critical vendor.” 

To coerce supplies to continue selling to debtors while they discharge from the bankruptcy process, debtors routinely request that courts approve “critical vendor” classification. Treatments routinely involve the debtor being authorized to designate suppliers believed to be essential to functions and to pay balances owed before bankruptcy to creditors. In exchange, vendors continue supplying debtors during Chapter 11 cases and on similar or better terms than before bankruptcy was pursued. Many people view critical vendor treatment as the best result for suppliers in Chapter 11, which lets vendors achieve recovery on debts owed before bankruptcy when they otherwise had a claim that might not have ever been paid. 

“Critical Vendor” Classifications Functions as Defense to Preference Claims

When it comes to preference claims, suppliers routinely argue “critical vendor” status as well as the payment of pre-bankruptcy balances functions as a defense to subsequent preference claims. The epitome of this claim involves a supplier who lacked preferential treatment because if the entity had not been paid before the bankruptcy, the supplier would have received compensation after bankruptcy as a method of obtaining “critical vendor” status. 

In Insys Liquidation Trust v. McKesson Corp., a Delaware judge declined to accept this argument and found that approving critical vendor treatment for a supplier at the beginning of a Chapter 11 case does not prohibit a preference claim to recoup payments to a supplier before bankruptcy. In the Insys case is in other Chapter 11 cases, the court’s decision to approve critical vendor treatment did not name specific vendors to be paid and as a result, left the matter in the discretion of the debtor to make these designations, and payments were made to the supplier in accordance with the order were discretionary with the debtor subject to negotiations with suppliers and not mandatory. The terms of the critical vendor included a statement that did not constitute a waiver of any causes of action against any creditor.

Based on these facts and relying on a 2004 decision by another bankruptcy judge, the  Insys Therapeutics judge concluded that the extension of critical vendor treatment to the preference defendant in the case did not bar subsequent preference claims. In the 2004 case, the judge noted that the critical vendor did not require the defendant’s pre-petition claims to be paid in full and did not provide that preferential payments made to the defendant could not be recovered. The judge also delineated several cases in which critical vendor treatment had protected creditors from later preference claims and noted that in these cases, the creditors either held priority claims that would have been paid under the Bankruptcy Code in any situation or were granted vendor status in an order or approved terms that required their pre-bankruptcy claims to be paid in full. 

In the current case, the judge found that the fact that a creditor was authorized to obtain treatment as a critical vendor at the beginning of the case and subject to the debtor’s discretion was not enough to prohibit a preference claim.

Recommended Strategies for Critical Vendors

Following the landmark ruling in Insys Therapeutics and given the emphasis that bankruptcy courts place on Delaware decisions, suppliers to Chapter 11 debtors that receive critical treatment under the most common types of court orders cannot count on this status to act as a defense if they are subsequently sued for the recovery of pre-bankruptcy payments received during the preference period.

If substantial preference exposure is present, suppliers should seek to have a court’s critical vendor order or a separate stipulation with a debtor submitted for court approval. This order should address the “something more” or language that necessitates the debtor paying the supplier’s pre-bankruptcy balance in full or expressly provides for a waiver of any later preference claims against the supplier with the express waiver functioning as the preferred approach. In either situation, parties should clarify that any language that has been appropriately noticed to all interested parties before an order is entered and will be binding on the debtor and any trustee or creditors committee that will later be authorized to assert such claims.

Obtain the Assistance of an Experienced Bankruptcy Attorney

The bankruptcy process is constantly evolving. To make sure that you utilize the most recent law to your advantage, it can help substantially to obtain the advice of a knowledgeable lawyer. Contact bankruptcy attorney Melanie Tavare today to schedule a free case evaluation.