From the August 24, 2005 edition of The Daily Bankruptcy Review – Small Cap
Despite the recent and well-publicized Seventh Circuit ruling in the Kmart case placing much tighter restrictions on critical vendor payments, these motions continue to be granted routinely in other Circuits. Typically, the orders do not mandate payment and leave the debtor with considerable discretion over what payments are to be made and to which vendors. They simply require that the vendor continue to provide goods and services under normal terms.
Surprisingly, in light of different treatment of critical vendor motions by the bankruptcy courts, the recent legislative changes to the Bankruptcy Code provided no guidance on what circumstance, if any, critical vendor motions should be granted.
Until the courts or legislature provides a uniform rule on motions for critical vendors, professionals will have to cope with the difficulties these issues present. However I believe effective management of the vendor base can be accomplished by carefully weighing who a true critical vendor is and by taking the stance that vendors want and need the debtor to successfully reorganize and therefore, should act in its best economic interests. Following are some practical considerations to keep in mind.
Critical vendor dynamics
A Chapter 11 case is generally a zero-sum game with all creditors classes and equity jockeying for leverage and to ultimately maximize their recovery. It is not surprising that unsecured trade creditors -- critical, not critical or somewhere in the twilight zone -- seek and pursue all available avenues to improve their piece of the pie.
In several recent Chapter 11 cases where I was engaged, debtors filed critical vendor motions, which were granted. In each of these cases the dollar amount of critical vendor payments that could be made was proposed by the debtor and approved by the Court. The debtors were provided with considerable latitude and discretion concerning what amount, if any, a specific vendor would receive. In each case the debtor engaged heavily in negotiating critical vendor payments with a variety of potential critical vendors. Not surprisingly, in most instances, all vendors who learned that a critical vendor motion had been approved considered their goods or services critical and sought critical vendor status. Large vendors who were single-source suppliers or knew that replacing their goods or services would not be easy were the first to strike, usually with aggressive and knowledgeable legal counsel. These suppliers had the most leverage and were most successful in extracting significant payments.
A critical vendor “wannabe” and “can be”
Vendors seeking critical vendor status generally can be stratified in three (3) categories (i) a true critical vendor, (ii) a vendor easily replaced, and (iii) a wannabe critical vendor who screams loudly for a critical vendor payment and uses short-term negotiating leverage.
In one particularly difficult and perhaps egregious situation, a large well-known and financially strong vendor contacted both the debtor’s CFO and legal counsel with a demand for an immediate ‘all-hands” conference call. The vendor was very aware of its single-source status and the business interruption it would cause by not shipping. The vendor could effectively destroy the debtor’s ability to reorganize. Its demands were high, 90% payment on prepetition debt, an agreed-upon reclamation claim and a “promise” that preference claims would not be asserted. On the advice of legal counsel, the debtor capitulated to all demands.
A true critical vendor
On the opposite spectrum in the same case we had a truly critical vendor as we defined it.
The debtor constituted over 50 percent of the vendor’s business. The debtor and the vendor had a partnering relationship where the vendor was practically an extension of the debtor’s business. The vendor was relatively small and the debtor had already extended normal payments well beyond normal terms. There was no doubt that without a significant payment on the outstanding balance the vendor itself would not be viable and shipment of critical components necessary for the debtor to continue viable operations would be compromised. The amount of the payment to the vendor was negotiated and paid.
Potentially gray areas
In another case, after reviewing the situation, I argued not to file any critical vendor motion. This advice was based on the assessment that the debtor had no true critical vendors and that a first-day motion would be counterproductive. A typical press release was issued and all vendors were contacted the day of the filing. The question of critical vendor ‘money” was raised by several vendors. Once told that no such motion was filed, the negotiations in most instances moved on to postpetition terms - - certainty and timing of payment on postpetition shipments, etc. There was no interruption of needed supplies or services. This course of action should be the general rule, not the exception.
In another case a critical vendor motion was granted, but no payments were made. Instead of making critical vendor payments, quick postpetition payments and deposits were offered and accepted in all major instances. This stance was taken on the belief that the vendors needed and wanted the debtor to reorganize and would act in their best economic interest. The debtor did not experience any interruptions in its flow of goods and services.
Potential critical vendor strategies
Critical vendor payments are not meant to be a giveaway to certain creditors at the expense of other creditors. They are designed to maximize value. Before filing a critical vendor motion, the debtor should consider the following:
- Does the debtor have true critical vendors -- vendors who are not replaceable and who will not be able, or willing, to provide goods to the debtor after the filing if they are not paid.
- If there are no “critical” vendors, do not file a first-day critical vendor motion. Once such a motion is granted, negotiating dynamics are different than they are in the absence of such a motion. Nevertheless, be prepared to file a motion if needed. Address the issue with the secured creditor prior to filing.
- Instead of a critical vendor budget, budget for vendor deposits, cash on delivery or prepayments.
It may be years before lawmakers or the courts provide a single answer on handling critical vendor issues. However, professionals can maneuver through difficulties presented by critical vendor issues by first identifying true critical vendors and then effectively managing and negotiating with the vendor base.
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Ken Naglewski is a Managing Director at Focus Management Group and located in the firm’s Nashville, TN office. Naglewski has over 20 years experience advising distressed businesses in a wide array of economic sectors both in the U.S. and abroad. He has played an active leadership role in Chapter 11 bankruptcies, financial restructurings, operational turnarounds and distressed business sales. Recently he has specialized in providing advisory services and expert testimony on behalf of lenders and debtors in a large number of Chapter 11 cases. Naglewski is a CPA as well as a CTP and Certified Insolvency and Restructuring advisor. He can be reached atk.naglewski@focusmg.com.