The Restructuring Report

In the days leading up to a Chapter 11 filing, companies seeking bankruptcy protection commonly ask whether they can continue to pay some of their vendors after the bankruptcy case is filed. On the flip side, in the days following a Chapter 11 filing, vendors whose customer recently filed a bankruptcy case have the same question – can we still get paid?

The baseline rule is clear: the company can, and must, pay its suppliers in the ordinary course for goods or services that it receives after the case is filed. These goods or services, to the extent they benefit the estate, would provide the basis for an administrative claim if unpaid. But what about bills for goods or services that were provided before the case was filed? In general, no. The company generally cannot pay “prepetition” claims without court authorization. In practice, companies filing a Chapter 11 case have obtained emergency orders from the bankruptcy court permitting them to pay certain “critical vendors.” These are suppliers or other parties whose ongoing relationship with the company is key to the company’s attempted reorganization and who therefore have some leverage to demand payment.

Over fifteen years ago, this practice was thrown into disarray following a decision by the Seventh Circuit Court of Appeals, which held that Kmart Corp. had not provided sufficient evidence to justify paying its chosen vendors. Since that time, smart professionals have developed an approach to determining which vendors are truly “critical” and documenting that evidence in a confidential manner somewhat in tension with the public nature of bankruptcy proceedings. That practice was upheld by the District Court for the Southern District of New York in the Windstream Holding Inc. case and a further appeal was dismissed as moot, providing a template for practitioners across the nation seeking to effectively implement and manage a critical vendor process in the midst of the potential chaos of a Chapter 11 filing.

In the Windstream Holding Inc. Chapter 11 case, the debtors obtained blanket authority to pay up to $80 million to critical vendors but did not tell the court the identity of any of the proposed critical vendors or the amount of each payment. The debtors represented that their professionals would assess ten factors about each vendor to determine whether (i) the vendor was critical and (ii) payment was necessary to maintaining the relationship with the vendor.

The debtors then provided a list of proposed critical vendors and applicable payments to the official committee of unsecured creditors and the United States Trustee. The lists were not filed with the court so as to not undercut the debtors’ ability to negotiate with their vendors. In fact, if neither the committee nor the U.S. Trustee objected, the court had no role in determining whether a vendor was critical or should be paid. A disgruntled vendor (who obviously was not determined to be “critical”) appealed, arguing that this impermissibly delegated the court’s decision-making authority. The district court disagreed and approved the procedure.

The ten questions used by the debtors’ professionals to assess whether to make a “critical vendor” payment were:

1. whether certain specifications or contract requirements prevented the debtors from obtaining goods or services from alternative sources;
2. whether a vendor was a sole-source, limited-source, or high-volume supplier of goods or services critical to the debtors’ business operations;
3. whether an agreement existed by which the debtors could compel a vendor to continue performing on prepetition terms;
4. whether alternative vendors were available that could provide requisite volumes of similar goods or services on equal (or better) terms and, if so, whether the debtors would be able to continue operating while transitioning their business to the alternative vendors;
5. the degree to which replacement costs (including pricing, transition expenses, professional fees, and lost sales or future revenue) exceeded the amount of a vendor’s prepetition claim;
6. whether the debtors’ inability to pay all or part of the vendor’s prepetition claim could have triggered financial distress for the applicable vendor;
7. the likelihood that a temporary break in the vendor’s relationship with the debtors could have been remedied through use of the tools available in Chapter 11;
8. whether failure to pay all or part of a particular vendor’s claim could have caused the vendor to hold goods owned by the debtors, or refuse to ship inventory or to provide critical services on a post-petition basis;
9. the location and nationality of the vendor; and
10. whether failure to pay a particular vendor could have resulted in contraction of trade terms as a matter of applicable non-bankruptcy law or regulation.

While there is significant overlap between the ten questions, that is to be expected, as all ten questions are trying to get at the same underlying one question: is it worth it to pay this vendor more than it would be strictly entitled to receive under the Bankruptcy Code? The decision provides welcome guidance, protects the estate from unnecessary disclosures that could be harmful to the estate’s interests and will likely institutionalize the procedures that were used in the Windstream case. In the busy days surrounding a Chapter 11 filing, debtors’ professionals would be wise to take a page from the Windstream playbook.