Blakeley & Blakeley LLP Fall 2006 THE TRADE www.bandblaw.com VENDOR QUARTERLY Developments in Commercial, Creditors’ Rights, E-Commerce, and Bankruptcy Law of Interest to the Credit and Financial Professional

IMMUNIZING PAYMENTS should the vendor receive payment by RETURNED INVENTORY AS FROM PREFERENCE RISK: credit card during the preference period? A PREFERENCE CLAIM:

THE CREDIT CARD DE- The bankruptcy court in In re Perry2 WHAT IS THE VALUE? FENSE? recently considered whether a vendor must disgorge payments as a preference, even Bradley Blakeley though the payment was made by credit [email protected] Scott Blakeley [email protected] card. The court dismissed the preference Preference claims are suit. While the Bankruptcy Reform Act one of the more fre- The credit executive is gives greater protection to vendors in chal- quently litigated issues well aware of the skill lenging a preference suit under the ordinary in bankruptcy, and the needed to collect on a course of business defense, the vendor still typical preference claim delinquent account, yet has several hurdles to overcome the prefer- is based on a debtor's maintain the trade credit ence challenge using the ordinary course of payment of antecedent debt. However, relationship, if manage- business defense. The goods news for sometimes a preference claim is based on ment is concerned about possibly losing the credit executive’s with the Perry ruling is the debtor's return of inventory to the credi- customer to a competitor. With new orders, that the vendor is not required to prove up tor in return for a reduction of the creditor's the credit executive’s job is to ensure that the common preference defenses, but dis- claim. The few reported decisions concern- the debtor pays close to the invoice due missed the case based on the trustee’s fail- ing return-of-inventory preference claims date. However, should the customer face a ure to prove up the preference elements. have addressed the determination of the cash crisis, they likely do not have suffi- The court’s ruling and its meaning to ven- value of the inventory returned by applying cient liquid assets to pay the vendor’s in- dors is considered. various methods. The most recent case voice. Given this, the credit executive may from the U.S. District Court for the Western look to alternative payment methods. The A. Accepting Payment By Credit Card District of Virginia in Active Wear Inc. v. credit executive, in implementing a strategy in B2B Transactions Parkdale Mills Inc. applies yet another to collect the delinquent account, may need method of valuation, limiting a chapter 11 to balance ways to minimize the risk of a Not so long ago, a credit executive debtor's recovery on a return-of-inventory bankruptcy preference suit (or strengthen accepting payment by credit card for a B2B preference claim to the amount the debtor defenses) should the customer later file transaction was an aberration. Not so to- would have realized from a liquidation sale bankruptcy within 90 days of receiving pay- day. Payment by credit cards involving B2B of the inventory. ment. Payment by credit card may be the transactions continues to increase, with over answer. But what of the preference risk, $100 billion in payments this year. Ven- The debtor, Active Wear Inc., turned dors, as sellers, accepting payment by credit yarn into cloth and purchased substantial CONTENTS card consider several advantages to pay- amounts of yarn from Parkdale Mills Inc. ment by check or other forms of payment, Immunizing Payments from Preference Risk 1 During its period of operation, the debtor such as: immediate payment and therefore purchased substantial quantities of yarn on Returned Inventory as a Preference Claim: What is improved cashflow, increased sales, facili- the Value? 1 open account from the creditor, Parkdale tates collections as there is no accounts re- Mills, Inc. When the debtor ceased opera- Court May Refuse Ordinary Course of Business 2 ceivable, reduced administrative costs, tions, it had unused yarn in its possession Defense Based on the Method Used in Applying minimize documents, improve financial Payment to Outstanding Invoice which it had purchased from the creditor, at planning and reporting and customer con- which time it owed on its account with the U.S. Automotive Industry: Credit Executives’ Latest 2 venience. Challenge creditor at least $2 million.

Protect the Helping Hand: When Keeping the Debtor 3 B. The Preference Action and Property Afloat to Help Yourself, Do it Right When the debtor ceased operating, the of the Estate creditor sent a reclamation demand to the You’ve Been Selected as a Critical Vendor, Now 3 What? Negotiating Points debtor for recovery of yarn having the value Should the credit executive receive Bankruptcy Preference and State Mechanic’s Lien 4 payment by credit card and the customer Laws (Continued on page 13) (Continued on page 12)

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COURT MAY REFUSE ORDI- Guest Column NARY COURSE OF BUSI- FROM THE PUBLISHER : U.S. AUTOMOTIVE INDUS- TRY: CREDIT EXECUTIVES’ NESS DEFENSE BASED ON The Trade Vendor Quarterly is published THE METHOD USED IN AP- by the law firm of Blakeley & Blakeley LATEST CHALLENGE PLYING PAYMENT TO OUT- LLP and is distributed as a service to cli- ents and other parties interested in credi- Dorman Wood, CEW, CCE STANDING INVOICE tor issues. This information is not in- [email protected] tended to constitute legal advice, nor a Shirley Chen substitute for legal advice. At one time or an- [email protected] other, most everyone has Blakeley & Blakeley LLP cannot be held seen the video of a long A primary policy under- responsible for the accuracy of informa- serpentine chain of falling lying section 547(c)(2) tion contained in articles written by guest dominos. With this image (C) of the Bankruptcy contributors. Readers’ comments and in mind, picture the falling Code is to prevent par- questions are welcome and should be ad- dominos labeled with the ties from creating unique dressed to: names of the companies payment terms that within the U. S. automotive would allow the debtor to manipulate the Scott Blakeley industry who have filed bankruptcy within the timing of the payments so that it appears Blakeley & Blakeley LLP, past year: Tower Automotive, Inc. (2/05); that those payments are consistent with Wells Fargo Tower, Meridian Automotive Systems Composites debtor's overall payment history. In In re 2030 Main Street, Suite 210, Operations, Inc. (4/05); Collins & Aikman Bridge Information Systems, 331 B.R. 774, Irvine, CA 92614. Corp. (5/05); Delphi Corp. (10/05); Dana the court concluded that the supplier failed Corp. (3/06), and most recently, Dura Aut o- to establish its practice of allowing the Telephone: 949-260-0611 motive Systems, Inc. (10/06). debtor to direct which payments should Facsimile: 949-260-0613 apply to which invoices was objectively How many more “automotive industry” ordinary within the computer resale indus- dominos will fall is subject to analysis and try. debtor made each of the payment during the speculation by industry experts. ninety day preference period, and the debtor In Bridge, the plan administrator for made each of the payments to the supplier. “The shake-out of General Motors and the debtor filed an adversary complaint Ford Motor during 2005 has caused the most against the supplier seeking to recover pay- The court stated that the plan adminis- violent and wide-spread dismantling of the U. ments that the debtor made to the supplier trator must also show that the debtor made S. auto parts supplier sector in the more than as preferential transfers. The supplier each of the payments on account of an ante- century-old history of the automobile. The claimed that the plan administrator may not cedent debt as required by 11 U.S.C. § 547 suppliers sector represents the ‘undercarriage’ avoid the payments under the ordinary (b)(2). The payment summary provided by of the auto industry: It produces the brakes, course of business defense. the supplier's general manger indicated that electrical wiring, shocks/struts, seats and the debtor remitted payment to the supplier other vital components. The debtor and the supplier entered after the thirty day due date for the vast into an agreement where the supplier agreed majority of invoices in both the pre- The automotive suppliers’ collapse re- to resell computer components parts and preference and preference period. How- minds us that the auto sector crisis is not systems to the debtor. The terms of the ever, the debtor also made some of the pay- months away, but upon us.” agreement required the debtor to remit pay- ments before the thirty day due date. ment on each invoice within thirty days of “During recent years, the Big Three U. its receipt of the invoice. The agreement The court reasoned that a debt is in- S. automakers Ford, GM and DaimlerChrys- also mandated that the debtor remit pay- curred on the date upon which the debtor ler have been under tremendous pressure to ment directly to supplier’s bank. The first becomes legally obligated to pay it. A reduce costs. Viewed by some within the agreement also allowed the debtor to match debtor incurred a debt on an obligation once industry as relentlessness, their cost cutting each payment with any outstanding invoice. the creditor would have a claim against the efforts included plant closures, worker lay- debtor’s estate if the debtor fails to pay for offs, and demands on suppliers to reduce During the ninety day preference pe- the goods or services provided. Because prices. riod the debtor made eight payments to the the debtor’s obligation to pay the creditor supplier totaling $2,155,105.80. The plan arises as soon as it receives the goods or Epitomizing the manner by which the administrator attempted to avoid these pay- service in question, the debtor incurred a Big Three automakers forced auto suppliers to ments as preferential transfers under 11 U. debt when it received the goods or services cut their prices, and thus accelerating the sup- even if payment was not due until a later S.C. § 547(b). The parties stipulated that pliers’ collapse, is the case of Troy, MI-based the debtor was insolvent at the time it remit- date. Since the debtor made the payments Collins & Aikman, which produces parts for ted each of the payments to the supplier. after it received the computer components, 90% of the vehicles that are built in the The plan administrator demonstrated that even if the payments were made prior to the United States.” thirty day due date, each of the payments the debtor remitted each of the payments after it had received the computer product (Continued on page 5) and the corresponding invoice, that the (Continued on page 12)

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PROTECT THE HELPING for two weekly payroll obligations. The YOU’VE BEEN SELECTED HAND: WHEN KEEPING first instance required approximately AS A CRITICAL VENDOR, $28,000, and the second required approxi- THE DEBTOR AFLOAT TO mately $16,000. Because the deposit was NOW WHAT? NEGOTIATING HELP YOURSELF, DO IT now depleted, Employee Professionals re- POINTS RIGHT quested Debtor to restore the deposit to the required $45,000 level. As requested, Scott Blakeley Debtor provided $45,000 to Employee Pro- [email protected] Sandy Soo fessionals. [email protected] The credit executive well knows that a In In re Sp ancrete of CORE sought a determination that the customer’s Chapter 11 means long delays Florida, Debtor entered $45,000 held by Employee Professionals before receiving payment on the prepetition into two construction was not a property of the Debtor’s estate, account, which payment is usually but a contracts with CORE therefore allowing CORE to recover the fraction of the claim. Indeed, it is not un- Construction Services funds and use them to pay amounts due to common for the vendor to receive stock in Southeast, Inc. (CORE) the Debtor. the reorganized debtor in exchange for its to supply and install pre-cast, hollow-core prepettion claim. Traditionally, the vendor concrete planks at two condominium com- Property belonging to a debtor’s estate would file a proof of claim, perhaps serve plexes. After Debtor began experiencing is defined broadly as “all legal or equitable on the creditors’ committee, and press the financial problems, CORE assisted Debtor interests of the debtor in property as of the debtor for a meaningful payment. Does a by making payments to Debtor’s suppliers commencement of the case…wherever lo- vendor in this situation, especially one with and vendors because it was anxious for cated and by whomever held.” 11 U.S.C. substantial trade relationship, have any ad- Debtor to complete its obligations under the section 541. ditional alternatives? Fortunately, with the construction contracts. CORE believed that development of the critical vendor doctrine, the payments to third parties were payments The court likened the situation to that the credit executive may have an alternative made to Debtor, and the amounts would of an escrow agreement. After conditions that may result in payment in full. offset any amounts due and owing to precedent occur, one party is entitled to Debtor under the construction contracts. receive the funds held in trust. Here, the The critical vendor doctrine most com- Debtor, on the other hand, believed that the funds were intended to be held in escrow by monly applies where a vendor is a key sup- payments were contributions of capital. Employee Professionals and to be used by plier. Given this key supplier relationship, Employee Professionals to pay any out- the vendor often holds a sizeable unsecured Under the arrangement, Employee standing invoices. The $45,000 deposit claim upon the Chapter 11 filing. The ven- Professionals would be paid because it han- provided by CORE was used by Employee dor, selling invoice by invoice (as opposed dled Debtor’s payroll and managed the Professionals to pay outstanding invoices. to a long term supply contract), may elect compensation services for Debtor’s em- Any interest CORE had in the funds held by not to continue to sell the debtor postpeti- ployees. If Debtor received an invoice from Employee Professionals disappeared when ton. However, the vendor’s product or ser- Employee Professionals that it could not the initial $45,000 was depleted. The sec- vice may be viewed by the debtor as essen- pay, then Debtor would forward the invoice ond deposit of $45,000 was provided by the tial to its continued operations. to CORE for payment. Debtor, and CORE has no cognizable inter- est in the replenished funds. In this situation, the debtor may re- The Debtor forwarded invoices, dated quest that the court authorize it to immedi- January 14, 21 and 28, 2005, to CORE for How could CORE have protected it- ately pay the vendor’s prepetition claim, in payment. CORE paid those Employee Pro- self? In T & B Scottdale Contractors, Inc. exchange for the vendor selling to the fessionals the invoices by wire transfer. On v. United States, the debtor-subcontractor debtor postpetition on credit. Under the February 1, 2005, Employee Professionals, had a joint bank account with a general con- critical vendor doctrine, a vendor may find concerned that Debtor would not be able to tractor. The debtor-subcontractor would that the product or service it provides a make future payments, requested $45,000 submit invoices to the general contractor, Chapter 11 debtor is essential to continued be deposited with them for use if Debtor who would then deposit enough funds in the operations. The uniqueness of the product could not pay for services rendered, or if account to cover the invoice. The agree- or service may give the vendor leverage in Debtor had an outstanding balance with ment between the general contractor and the negotiating postpetition sales. Employee Professionals when it ceased to debtor-subcontractor specifically stated that operate. Included in its wire transfer pay- account funds were only for paying materi- Notwithstanding the Seventh Circuit ment of the February 4, 2005 invoice, almen. The court held that the deposited Court of Appeals decision in Kmart, bank- CORE provided the $45,000 deposit that funds were held for the benefit of another ruptcy courts continue to consider a Employee Professionals requested. CORE and therefore were not the property of the debtor’s request to treat certain vendors as also wire transferred payment for the Febru- estate. critical and have their prepetition claims ary 17, 2005 invoice from Employee Pro- paid in exchange for postpetition trade fessionals. The helping hand gets burned when credit. not adequately protected. Here, it was as Debtor filed its Chapter 11 petition on simple as inserting a clause in the agree- For the credit executive considering April 7, 2005. Employee Professionals ment which stated the financial assistance used the $45,000 deposit to provide funds provided was solely for the purpose of pay- (Continued on page 6) ing suppliers.

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BANKRUPTCY PREFER- the bankruptcy estate previously trans- IT Group, Inc., considered whether the ferred, the Bankruptcy Code carves out bankruptcy laws preempted a state’s lien, ENCE AND STATE ME- seven exceptions or defenses to the trustee's thereby opening the door for vendor to face CHANIC’S LIEN LAWS: IS recovery powers. The most commonly as- a preference claim. THE SUBCONTRACTOR serted exception by vendors is the contem- PROTECTED FROM THE poraneous exchange defense, the subse- Preference and the Subcontractor quent advance defense, and the ordinary PREFERENCE course of business defense. In In re IT Group, the debtor’s credi- tors’ committee sued two of its material Scott Blakeley Mechanic’s Liens suppliers for payments received during the [email protected] preceding 90 days the debtor’s bankruptcy State mechanic’s lien laws ensure pay- filing (preferences). The suppliers sought A fundamental responsibility of a ment to vendors extending credit for sup- to have the preference actions dismissed as credit executive is assessing a debtor’s plying labor and materials that improve the transfers were trust property under state credit risk. For credit executives employed property, by allowing the vendors to look to lien law and thus was not property of the by subcontractors and material suppliers, the owner of the property for payment. estate. states have created special protections to Many states provide for a payment bond in these vendors to reduce or eliminate credit lieu of a mechanics lien. In opposition to dismissal of the pref- risk through mechanic lien laws. However, erence action, the creditors’ committee con- what is the effect of the state lien laws The subcontractor must give prelimi- tended that the preference provision was where the general contractor files bank- nary notices to the property owner and ot h- intended to ensure equitable distribution to ruptcy? Are payments made to the subcon- ers, depending on the state statute. The all the creditors. The material suppliers tractor and materialman during the prefer- time limit is generally connected with the cited to cases wherein courts found that ence period recoverable by a bankruptcy last date on which the goods or services funds held in trust under state law for the trustee, or do the states’ lien laws protect have been supplied to a particular job. The benefit of subcontractors and material sup- the vendors from the preference risk? A subcontractor must also record a claim of a pliers was not a preference. recent bankruptcy case which considered lien in the county filing office. The me- the interplay of the state lien law and fed- chanic’s lien attaches to property immedi- The bankruptcy court concluded that eral Bankruptcy Code’s preference provi- ately when the claimant supplied the labor the material supplier and subcontractor sion is considered. or materials. The claimant must initiate a were entitled to judgment in their favor be- legal proceeding by filing a complaint for a cause the state lien law created a statutory The Bankruptcy Preference foreclosure and records a notice of lis trust. The funds were not property of pendens. The vendor must be mindful that debtor’s bankruptcy estate because the The Bankruptcy Code vests the debtor each state’s lien law may vary in terms of funds received by the general contractor for (or trustee if one is appointed) with far- notice requirements and protection afforded the improvement of real property is to be reaching powers to recover payments to the vendor. held in trust for the benefit of the subcon- vendors within 90 days of the bankruptcy tractors. The court noted that the prefer- filing. The power to avoid preferential Interplay of Federal Bankruptcy Prefer- ence defendants provided labor, services, transfers is one of the most powerful weap- ence Law and State Lien Law and materials in connection with the prime ons a trustee has. The bankruptcy prefer- contracts and therefore the preference ac- ence is part of the Bankruptcy Code, which Whether a vendor who is protected tions should be dismissed. The court ob- is a federal law that applies to all states uni- under a state’s lien law, must return prefer- served that the Bankruptcy Code did not formly. The purpose of the preference pro- ence payments when the general contractor preempt the state lien law. vision is two-fold. files bankruptcy raises the doctrine of pre- emption. A state’s lien laws are created by Conclusion First, unsecured creditors (or underse- the state legislature, while the bankruptcy cured creditors, e.g. those creditors whose laws are created by Congress and are a fed- The IT Group decision encourages the collateral is valued at less than their debt) eral statutory scheme. subcontractor and material supplier to con- are discouraged from racing to the court- tinue supplying their financially struggling house to dismember a debtor, thereby has- Preemption may exist if Congress general contractor. While the IT Group tening its slide into bankruptcy. Second, passes a federal law that is intended to court underscores that the particular state’s debtors are deterred from preferring certain block enforcement of a state law, here the lien law protects the vendor from a prefer- unsecured creditors by the requirement that lien laws. While Congress crafted the ence claim, be mindful that the state lien any unsecured creditor that receives a Bankruptcy Code to cover most aspects of laws are statutory and thus may vary from greater payment than similarly situated un- debtors and their creditors, there a number state to state. Vendors may use the IT secured creditors disgorge the payment so of state laws that also govern these rights. Group ruling as a means to negotiate a dis- that like creditors receive an equal distribu- missal or reduction in the preference de- tion of the debtor's assets. Where a court is requested to interpret mand, depending on the state lien statute. whether a state law, here the lien law, is Not all transfers made within the pref- preempted by a federal law, here the Bank- erence period are avoidable. To protect ruptcy Code, the inquiry is whether the state those transactions which replace value to law conflicts with the federal law. In a re- cent decision, the bankruptcy court in In re

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Guest Column ally held before the beginning of our indus- U.S. AUTOMOTIVE INDUS- The general direction of the company try credit group meetings now begins the TRY: CREDIT EXECUTIVES’ has been to lessen our dependence on the night before the meeting and continues automotive market and the Big 3 specifi- through to the following day. In the words LATEST CHALLENGE cally,” he said.” of Alfred E. Newman, ‘What, Me worry?’ ” (Continued from page 2) Several credit executives within the “My staff is spending more and time On October 20, 2006, CBS news re- automotive sector were questions about the on deduction resolution. Customers have ported that Ford would shutter l6 plants and pressures being placed upon their respective been increasing the number and value of hopes to cut 30,000 hourly jobs by the end firms by the events described above. deductions taken from payments to us, shift- of 2008. Ford reportedly has also offered Speaking on the condition of anonymity, ing the burden of ‘proof’ to us. Not only is buyout or early retirement offers to 75,000 their comments are as follows: this time consuming for my staff in terms of works. resolving the issues, it really constitutes an “Many of my fellow credit profession- interest free loan to the debtor for the time On October 21, 2006, The Detroit Free als in the automotive related industries are it takes for resolution, which requires much Press reported: “In the next two weeks, De- running scared. Despite the recent bank- haggling back-and-forth and in some cases troit auto suppliers are likely to report de- ruptcy filings, production cutbacks, plant can take up to six months.” clines in their third-quarter earnings per closures and labor-force layoffs, we are still share because Detroit’s automakers have under pressure from our executive manage- “Not much has changed within the scaled back production, forcing suppliers to ment to protect our accounts receivable automotive and related industries. My ex- make adjustments. assets and minimize losses.” perience in the industry dates back to the mid-80’s and even then the big players in DaimlerChrysler AG has said it will “Numerous suppliers to the automo- the industry were pretty much dictating cut North American production by 16%, or tive parts industry must rely on off-shore terms to the vendors who chose to do busi- 35,000 units, in the second half of the year. sources for their raw materials such as cop- ness with them. The same games are being General Motors Corp. estimates its North per, aluminum and steel. While we do our played today as back then; payments de- American production will be down 12% in best to hedge on pricing in the international layed beyond terms; unauthorized deduc- the final three months of the year, or about market place, we are being squeezed by the tions and continual pressures to reduce 50,000 units, from the fourth quarter of ‘big auto parts suppliers’ to cut prices and prices. All the while, we are expected to ‘do 2005. And Ford Motor Co. plans to cut its adjust production schedules to fit their more with less’.” North American production by 21% or schedules, while at the same time stretching 168,000 vehicles, in the final three months us out on payment terms.” As events continue to play out within of the year the automotive sector, which dominos will “Prior to filing bankruptcy, several of topple next?……..Lyons and Tigers, [but Lear Corporation, Visteon Corporation the ‘800 lb gorillas’ in the industry had no Bears]? Oh my……….sorry, I couldn’t and Johnson Controls, Inc. have all previ- come to us with ‘strong requests’ for ex- resist. Seriously however, one of the domi- ously reported they have already begun lay- tended payment terms, with the threat of nos to fall within the near future will be the offs in an effort to keep pace with the aut o- taking their business elsewhere. Since their filling of preference actions against credi- makers schedules. American Axle & bankruptcy filings, the same firm are voic- tors for the recovery of payments made by Manufacturing Holdings, Inc. has offered ing the same threat and still requesting ex- the auto parts suppliers within the ninety buyouts to 6,000 employees to align its tended terms.” (90) day “preference period” prior to the workforce with reduced customer orders.” filing of their petitions for protection under “Our firm has historically done busi- Chapter 11 of the United States Bankruptcy On October 28, 2006, BorgWarner ness within the industry under contractual Code. reported its profits were off 36 percent and terms, which in some cases covered pur- it missed its forecast. In September, chases over an extended period. Efforts to BorgWarner cut about 850 jobs, or 13 per- renegotiate the terms and period of these cent of its North American workforce due contracts prior to the bankruptcy filing of Mr. Dorman Wood is president of Dorman to a production slump. one customer were unsuccessful. Now, since Wood Associates, Inc. and advises creditors their bankruptcy filing, they have filed a as to their preference defenses, including Also on this date, the Timken Co. an- motion with the court to cancel the contract serving as an expert witness in such ac- nounced that 700 workers would lose their as ‘being unprofitable’.” tions. jobs. “Friday’s announcement was about matching demand in the market place,” “My firm was not a direct supplier of His email address is [email protected] President and Chief Executive Officer, parts or materials to the automotive indus- and his website is www.witness4u.com James W. Griffith said. try, rather we supplied construction materi- als to one of the parts supplier’s plant ex- “The automotive business has contin- pansion. Despite our properly filed lien ued to lag behind Timken’s industrial bear- rights, we were forced to hire an attorney to ing and steel groups, posting losses in quar- represent us in the bankruptcy proceed- terly returns. Griffith said the latest cuts ings.” will fit with the company’s push to diver- sify its customer mix. “The ‘Attitude Adjustment” hour usu-

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bankruptcy courts have often relied on the something that is done as a first day motion YOU’VE BEEN SELECTED "doctrine of necessity" to allow insolvent filed by debtors in chapter 11 cases. AS A CRITICAL VENDOR, debtors to pay vendors whose cooperation NOW WHAT? NEGOTIATING is deemed essential to a debtor's continued However, during the last four years, operations and reorganization. The same critical vendor payments have come under POINTS doctrine has been routinely invoked to jus- increased criticism by some courts, bank- (Continued from page 3) tify payment of the prepetition claims such ruptcy attorneys, and scholars. Some critics as claims of a debtor's employees for unpaid have noted that there is no provision in the this situation, how does the vendor make wages and benefits. Bankruptcy Code that expressly allows for the critical vendor list? What points does payment of critical vendors ahead of other the credit executive negotiate with the The necessity doctrine developed in creditors. Other critics have maintained debtor before committing to a critical ven- railroad receivership cases of the nineteenth that the Bankruptcy Code may allow critical dor contract? What is the impact of the century. Survival of the railroad industry vendor payments, but have argued that this Bankruptcy Reform Act to measuring post- was essential to a argel segment of the practice has been abused with payments petition credit risk, including available cash economy and communities in many regions being authorized when a vendor is not truly to fund critical vendor payments as well as of the United States, courts were willing to necessary to a debtor's reorganization. This pay postpetition credit extensions? If the be very flexible in allowing receivers over- criticism culminated in the Kmart appellate credit executive cannot negotiate a satisfac- seeing reorganizations of railroads to exer- rulings. tory critical vendor contract, what alterna- cise remedies necessary for a struggling tives are available for the credit executive to railroad to survive. These measures in- B. The Critical Vendor Doctrine preserve the sale to the Chapter 11 debtor? cluded the necessity of payment rule, which allowed payment of certain claims that To be classed as “critical” by a Chap- A. History of the Critical Vendor Doc- arose before receivers were appointed. Un- ter 11 customer is usually an extraordinary trine der this doctrine, claims made by suppliers result for the vendor as it usually means and other entities essential to railroad op- payment in full, or a substantial portion or Since the early 1990's, Chapter 11 erations could be paid ahead of claims that the prepetition claim, given the alternative debtors have asked bankruptcy courts to would otherwise have priority, including of waiting, perhaps for years but for a frac- approve payment of vendors’ prepetition claims of secured lenders. tion of the prepetition claim. However, a claims that it believes is essential to its on- Chapter 11 debtor’s funds available for the going operations. Payment of these claims 3. The Necessity Doctrine Outside critical vendor class is limited, especially has been allowed in the interest of enabling of Railroad Reorganizations with the enactment of the Bankruptcy Re- a reorganization that is expected to benefit form Act, and the constraints imposed by all creditors, including those that are not In the twentieth century, courts began the Seventh Circuit Court of Appeals under designated as a critical vendor. In some applying the doctrine of necessity to reor- the Kmart decision. Further, lenders, bond- jurisdictions, a motion to authorize payment ganizations of businesses other than rail- holders, noteholders, a creditors’ commit- of critical vendors' prepetition claims has roads, including businesses whose survival tee, the U.S. Trustee’s office, and even become a common first day motion in a was not necessarily linked to the public competing vendors who want to be elevated Chapter 11 case, wherein the debtor articu- interest. The doctrine of necessity is be- to critical vendor status scrutinize (and pos- lates its business judgment to support pay- lieved by its proponents to be incorporated sibly object) to the critical vendor request. ment of critical vendors. within a bankruptcy court's general equita- ble powers under section 105(a) of the Critical vendor motions are more com- 1. The Equality of Payment Rule Bankruptcy Code. mon -— and more scrutinized than ever. for Unsecured Creditors in Bankruptcy judges are now often insisting Bankruptcy The legislative history of section 105 on detailed support to pay a vendor immedi- (a) suggests that this section incorporates ately on their prepetition claim. Judges are A central principle of the Bankruptcy equitable powers that bankruptcy courts also granting immediate relief on an interim Code is equality of treatment of unsecured were previously understood to possess. The basis in order to give other parties involved, creditors. The equality of treatment rule is United States Supreme Court has stated that such as a creditor’s committee, time to re- embodied, for example, in the preference it will not read the Bankruptcy Code to view the request. laws and treatment of creditors’ claims un- erode the past bankruptcy practice absent a der a plan of reorganization. Creditors of clear indication that Congress intended such The critical vendor doctrine may be the same priority are generally not entitled a departure. viewed as conflicting with a fundamental to be paid on their prepetition claims in principle of bankruptcy which is equal Chapter 11, except through a plan of reor- 4. The Modern Approach to Criti- treatment (e.g. payment) for the same class ganization, and vendors are to be paid the cal Vendor Payments of unsecured creditors’ claims. In bank- same pro-rata amount on their claims in ruptcy, the general rule is that vendors may both Chapter 7 and Chapter 11 cases. During the past fifteen years, bank- be paid on their unsecured claims only ruptcy courts in a number of jurisdictions through a confirmed plan of reorganization 2. Deve lopment of the Necessity have been inclined to authorize debtors to or court-authorized liquidation. Doctrine pay repetition claims of vendors deemed

critical, based on a debtor’s business judg- A number of courts throughout the Notwithstanding the general rule of ment. The concept of "critical vendor" had (Continued on page 7) treating creditors of the same class equally, gone from an extraordinary remedy to

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have given critical vendor status to vendors YOU’VE BEEN SELECTED that have executory contracts. The debtor must establish: (1) Such AS A CRITICAL VENDOR, payments are in fact critical to their reor- NOW WHAT? NEGOTIATING C. Notwithstanding the Kmart Deci- ganization; (2)Discrimination among unse- sion, the Critical Vendor Doctrine cured creditors is the only way to facilitate POINTS Continues a reorganization; (3) Non-critical vendors (Continued from page 6) will be at least as well off as they would Kmart’s Chapter 11 was one of the otherwise be if the critical vendor order is country have carved an exception to this largest filings by a retailer. In an effort to not entered; and (4) Such payments will not general rule and labeled it the critical ven- obtain unsecured credit from its vendors diminish the amount of funds that ulti- dor doctrine. Under the doctrine, a debtor and maintain key vendor relationships, mately will be available for payment to may pay certain prepetition claims, with Kmart, in the opening days of the bank- non-critical vendors. In addition, the Sev- court approval, at the commencement of the ruptcy, rewarded certain key domestic and enth Circuit has expressed concerns about bankruptcy case where it can be established foreign vendors with payment on their pre- notice of a critical vendor motion to non- that payment of those claims will help to bankruptcy claims under the critical vendor critical vendors. stabilize the debtor’s business without sig- doctrine. As part of its first-day motions, nificantly harming any party. Kmart filed a motion seeking authority to D. Bankruptcy Reform Act Does Not pay prepetition obligations to its critical Bar Critical Vendor Doctrine, But The payment of these claims is to in- vendors. Kmart served its critical vendor Debtor’s Cash Availability Re- duce vendors to continue supplying key motion on about 65 of its key creditors, stricted goods and services post-bankruptcy on notwithstanding it had thousands of ven- credit, which may enable a debtor to con- dors. Kmart argued these payments were The Bankruptcy Reform Act is silent tinue to operate and perhaps exit bank- necessary to maintain business relationships as to the critical vendor doctrine. There- ruptcy. In exchange for the vendor being with the respective vendors, and the ven- fore, debtors are free to request the bank- paid in full, the debtor conditions the ven- dors' goods were essential to Kmart's con- ruptcy courts approve critical vendor mo- dor extending comparable credit terms post- tinued operations and a successful reorgani- tions. However, debtors will likely have petition. The critical vendor agreement is zation. less cash and liquid assets available to fund reflected in a letter agreement between the critical vendor requests as a result to debtor and the vendor. The agreement also Vendors supplying a range of products changes brought by the Reform Act. Like- provides for a “claw back” provision that from food to music to publishing services wise, vendors must be more vigilant with permits the debtor to recapture the critical were paid on their prepetition claims in ex- their postpetition credit analysis as a result vendor payment if the vendor refuses to change for these vendors providing post- of changes brought by the Reform Act. continue to extend credit. petition trade credit. The critical vendors agreed to provide credit on customary trade With the development of the critical 1. Selling to a Chapter 11 Debtor terms for two years. The bankruptcy court vendor doctrine, vendors found themselves Invoice by Invoice Compared authorized payments to the critical vendors committing to long term sales contracts— with an Executory Contract totaling $327 million under the “doctrine of on credit-in exchange for payment on their necessity” using its equitable powers of prepetition claims. Even those vendors that A vendor that has sold a debtor on an section 105 of the Bankruptcy Code. The did not qualify as “critical”-an amorphous order-by-order basis has no continuing obli- bankruptcy was satisfied with Kmart’s busi- standard-considered selling their Chapter 11 gation to sell the Chapter 11 debtor. Be- ness judgment that without paying vendors customers with the added inducement of a cause of this, the vendor has leverage on their prepetition debt the vendors would not junior lien on the customer’s assets. Some whether to sell the debtor. An element of make shipments postpetition, and without vendors, eager to continue the sale of its the debtor’s critical vendor request is that these goods Kmart’s reorganization would goods or services, would sell without any the vendor provides a product or service be threatened. credit enhancements. that is indispensable for its continued opera- tions. Should the critical vendor decide not The Seventh Circuit Court of Appeals Prior to October 17, 2005, vendors to provide the product or service, the pros- affirmed the district court's reversal of the would often measure postpetition credit risk pects for the debtor’s reorganization is di- bankruptcy court’s approval of the debtor’s by whether the debtor had obtained post- minished. critical vendor motion. The Seventh Cir- petition debtor-in-possession financing. If a cuit’s decision does not flatly reject the satisfactory DIP facility had been obtained, However, with the vendor who is a critical vendor doctrine, but it does indicate the vendor would sell on credit. However, party to an executory contract, such as a that a debtor seeking authority to pay its with the arrival of the Bankruptcy Reform long-term supply contract, the debtor may critical vendors must be prepared to satisfy Act of 2005, the credit risk model used by seek to compel the vendor to comply with heightened procedural and evidentiary stan- credit executives for selling to Chapter 11 the terms of the contract. The automatic dards. debtors may have fundamentally changed. stay bars the vendor that is a party to an executory contract with the debtor from The Seventh Circuit noted that the A debtor’s cash availability is re- terminating the contract postpetition, wit h- bankruptcy court ruling was overbroad stricted under the Reform Act as a result of out bankruptcy court authorization. Thus, where the court had allowed unlimited per- provisions favoring special creditor inter- only those vendors selling invoice by in- mission to pay any debt deemed critical. ests. Some of the provisions include: voice should have the leverage to seek criti- Rather, the debtor must identify which ven- (Continued on page 8) cal vendor status. Having said, that debtors dors are critical.

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ter 7 liquidation, often years after the filing, Vendor YOU’VE BEEN SELECTED even after the Bankruptcy Reform Act that AS A CRITICAL VENDOR, pressures debtors to exit bankruptcy earlier. The postpetition vendor agreement NOW WHAT? NEGOTIATING will control the terms of sale between the The critical vendor motion is filed by debtor and the vendor under the critical POINTS the debtor with the bankruptcy court and vendor agreement. (Continued from page 7) provides that the vendor will receive pay- ment on the prepetition claim. The order 1. How Much Are You Getting 1. Employee Wages approving the motion also binds the vendor Paid? that agrees to critical vendor status to con- Prior to the Reform Act, employee tinue to sell with the debtor on terms equal The critical vendor doctrine has wages were given priority up to $4,000 for to or better than pre-petition terms. The evolved from the debtor requesting a par- each individual earned within 90 days be- responsibility to define the vendors typi- ticular vendor be paid immediately as a fore bankruptcy. Under the Reform Act, cally has been placed in the hands of the critical vendor, to the debtor requesting a employee wages and salaries are increased debtors. When a company files for bank- class of vendors qualify as critical vendors, to $10,000 for each individual up to 180 ruptcy, it reviews a list of its vendors and to the debtor requesting the bankruptcy days before the bankruptcy. decides which ones are critical in order to court establish a critical vendor “trade stay in business. claims cap”. For example, in the United 2. Landlord Claims Airlines Chapter 11, the carrier requested Another strategy for a debtor is not that the bankruptcy court pay trade claims Under the Reform Act, a debtor must identifying their critical vendors in court totaling $35 million as critical. United Air- assume or reject its real estate lease within pleadings, which are public documents, to lines did not identify the vendors it would 120 days following the petition date. A avoid alienating those vendors who don’t deem critical. Rather, United Airlines re- court may extend the 120 day period to as- make the list. It seems the leverage of the quested the court authorize payment of a sume or reject for up to an additional 90 critical vendor request may be shifting from class of vendors it deemed critical which days. Further extensions require the lessor's the vendor to the debtor. The vendor may represented about 14% of vendors unse- consent. Early assumption requires the hold out continued sales to the debtor cured claims. United Airlines did not pro- debtor to dedicate more of its liquid assets thereby threatening the debtor’s ongoing pose to pay in full each vendor deemed to the early stage of the case. operations, perhaps only to find a replace- critical, but only the minimum for the ven- ment vendor who qualifies as a critical ven- dor to continue selling on credit. 3. Utilities dor. 2. Length of Postpetition Trade Under the Reform Act, a debtor offer- 1. Dealing with the Automatic Commitment ing a utility an administrative expense claim Stay no longer constitutes adequate assurance of How long are you committing to pro- payment. Adequate assurance of payment The automatic stay is an injunction vide your product or service? Through con- is limited to: a cash deposit; a letter of that automatically and immediately goes firmation? Post confirmation? With the credit; a certificate of deposit; a surety into effect upon the bankruptcy filing. It is development of the critical vendor doctrine, bond; a prepayment of utility consumption; filed, whether the bankruptcy filing is one vendors found themselves committing to or another form of security that is mutually under Chapter 7 or 11. long term sales contracts—on credit-in ex- agreed on. change for payment on their prepetition The automatic stay prohibits any credi- claims. Even those vendors that did not 4. Reclamation tor from taking action against the property qualify as “critical”-an amorphous stan- of the estate and against the debtor, unless dard-considered selling their Chapter 11 The Reform Act expands the time for relief from the stay is obtained. For exam- customers with the added inducement of a reclaiming creditors to make their reclama- ple, a vendor is barred from seeking or junior lien on the customer’s assets. Some tion demand to 45 days after the debtor re- levying writs of attachments or garnish- vendors, eager to continue the sale of its ceives the goods or 20 days after the bank- ments, and also stays the vendor from a goods or services, would sell without any ruptcy. The value of the goods shipped to judicial lien against the debtor, but has not credit enhancements. the debtor within 20 days prior to the bank- yet levied on any property. ruptcy are given an administrative claim. Prior to October 17, 2005, vendors This means that more of the debtor’s assets The creditor needs to be mindful when would often measure postpetition credit risk will be dedicated to reclamation claims. requesting critical vendor status that the by whether the debtor had obtained post- manner in which the request is made does petition debtor-in-possession financing. If a E. Making the Critical Vendor List not violate the automatic stay. To that end, satisfactory DIP facility had been obtained, the creditor should consider contacting the the vendor would sell on credit. However, A Chapter 11 debtor that is an operat- customer (debtor) and determine who with the arrival of the Bankruptcy Reform ing business must decide which vendors within the company is responsible for the Act of 2005, the credit risk model used by they need most, and then negotiate a pay- critical vendor program. Once that contact credit executives for selling to Chapter 11 ment. The debtor places the “critical” ven- is identified, the vendor may negotiate with debtors may have fundamentally changed. dors on a list. Those vendors that do not the representative to make the list. make the list will receive payment through (Continued on page 9) a confirmed plan of reorganization or Chap- F. Negotiating Points for the Critical

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If the postpetition trade credit agree- when the vendor ships postpetition on YOU’VE BEEN SELECTED ment does not contain a provision that al- credit, the debtor’s payment on the postpeti- AS A CRITICAL VENDOR, lows for the vendor to terminate the trade tion sale pays down the prepetition debt. NOW WHAT? NEGOTIATING relationship should the debtor fail to pay The vendor’s postpetition debt builds up, according to the credit terms, the vendor which is entitled to administrative priority, POINTS should write in such a provision. Further, and is ultimately paid down after the cross- (Continued from page 8) the vendor may want to include a provision collateralized prepetition debt is paid. that permits the vendor to terminate the trade relationship if the debtor falls below 7. Debtor Waivers to Protect the 3. Debtor Defaults on Postpetition key financial ratios, even if the debtor has Critical Vendor Credit Purchase not defaulted on the postpetition credit agreement. This would allow the vendor to The vendor should negotiate certain If the debtor fails to pay per invoice hold orders in the face of a debtor’s deterio- waivers to ensure that the critical vendor terms what are your rights? Can you re- rating postpetition financial operations. payment made is not later clawed back. voke your postpetition credit contract, yet preserve critical vendor payment? How do 6. Timing of Critical Vendor Pay- a. Preference Waiver you get paid on the delinquent invoices? ment Although the vendor may be deemed a 4. Postpetition Credit Risk When do you get paid on your prepeti- critical vendor, that designation does not tion debt? Is the debtor attempting to force protect the critical vendor from a preference The vendor needs to ensure that its vendors to ship on credit prior to making suit for payments received during the pref- postpetition credit does not exceed its the critical vendor payments. The vendor erence period. The vendor should insist on prep etition debt, unless comfortable with should negotiate immediate payment for the a preference waiver, for any payments you the credit risk. For example, the vendor full amount, if possible. You may be able received during the preference period. Ab- may have a nominal pre-bankruptcy bal- to do this through assumption of your con- sent an express waiver that is approved the ance, yet the debtor is entering their selling tract, also. bankruptcy court, you are at risk of a trustee season, and therefore under the terms of a demanding the return of the preference pay- common critical vendor agreement, the ven- 7. Payment Terms on Prepetition ment. dor has committed a sizeable postpetition Debt credit risk. As noted, with debtors filing b. Disgorgement Waiver in the Chapter 11 under the Reform Act, vendors a. Immediate Payment in Full Event of Conversion must be mindful that they have less cash to meet operating expenses. Therefore, there As noted, the vendor should negotiate Does the critical vendor face risk that may be even greater credit risk for the ven- immediate payment in full of the its prepeti- the critical vendor payment may be clawed dor contracting for postpetition credit sales. tion claim. back if the Chapter 11 be converted to Chapter 7 liquidation? If the critical vendor In evaluating the credit risk under the b. Payments Over Time order provides that the vendor is free from Reform Act, the vendor needs to consider such claims if the case converts from a the cash commitment and administrative Another alternative a debtor may offer Chapter 11 to a Chapter 7, that language claims that the debtor faces at the filing date to vendors immediate payment in full of its should protect the vendor from any later as well as the confirmation of the plan. critical vendors, is to pay those vendors claims asserted by a Chapter 7 trustee. prepetition claims over time, for example 5. Amount of Postpetition Credit over several months. As with the percentage c. Disgorgement Waiver in the Terms payment, there is no legal basis that re- Event of an Appeal quires a debtor to pay the vendors’ prepeti- What are the postpetition credit terms tion claim immediately. Kmart has raised the issue of whether a the debtor expects the vendor to commit to vendor that is selected as a critical vendor qualify as a critical vendor? The debtor c. Payment of Less than 100% may later be sued to recapture the critical commonly insists that the vendor provides vendor payment in the event the critical terms most favorable terms in the past six Under a critical vendor cap, the debtor vendor order be reversed, even if the vendor months. Generally, the debtor forwards a may offer only a percentage of each trade extended credit to the debtor as required letter agreement reciting the terms of the claim to be paid, say 60%. This allows the under the critical vendor order. A vendor postpetition agreement. debtor to offer more vendors to participate should consider including a provision in the in the critical vendor program, and thereby critical vendor order that bars a claw back Recent trade credit agreements ap- increase the amount of postpetition trade of the critical vendor payment should the proved by courts have required vendors to credit. order be reversed. The most effective way provide postpetition credit through confir- to gauge this risk is whether the critical mation of the Chapter 11 proceeding. If the d. Cross-Collateralization vendor order was appealed. The general vendor breaches the postpetition credit Provision rule is that the critical vendor order must be agreement, that may be cause for the vendor appealed within 10 days of entry. Should a to disgorge the payment on account of the A debtor may insist that the critical party fail to timely do so, the appeal is lost. prepetition claim. vendor payments be paid through the ven- (Continued on page 10) dor’s future shipments. In other words,

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G. If You Are Unable to Negotiate Fa- YOU’VE BEEN SELECTED d. Knowledge Vendors vorable Points to Support Critical AS A CRITICAL VENDOR, Vendor Status, Consider Critical NOW WHAT? NEGOTIATING Some vendors may be deemed critical Vendor Alternatives because they have unique knowledge of a POINTS debtor’s business, or have been responsible 1. Selling on Credit Postpetition (Continued from page 9) for certain aspects of a debtor’s business. These vendors have maintained the debtors To encourage vendors to sell a debtor 8. Proving up Uniqueness operations for a period of time and have postpetition on credit, the Bankruptcy Code acquired unique knowledge of the business. provides that should the debtor default on Although the debtor files the motion the credit sale, the vendor is entitled to an with the bankruptcy court to approve criti- e. Vendors Providing Unique administrative claim for the unpaid balance. cal vendor status, with those courts follow- Service Unlike the critical vendor doctrine, a post- ing the Kmart decision, the vendor may be petition credit sale does not allow for pay- required to provide specifics for the bank- Specialized service vendors are similar ment on the vendor's prepetition claim. ruptcy court, as well as creditors, as to why to unique product vendors, except that their vendor is so valuable to justify paying its uniqueness lies in their service instead of a. The Catch Up Issue claim ahead of other vendors. To that end, their goods. the vendor should review the debtor’s mo- If the vendor does not qualify as a tion to pay critical vendors and determine f. Lack of Competition within critical vendor, the vendor may decide to whether the debtor has classified vendors. Industry find an alternative to have its prepetition Below are examples of types products or claim paid. A vendor may not be paid on its service that may qualify the vendor as Lack of competition within an industry prepetition claim post bankruptcy. How- unique. Likewise, below are examples may give a vendor leverage over the debtor ever, a vendor may attempt to have the where the competitive situation may make and result in critical status for the vendor. debtor pay down its prepetition debt by in- the vendor unique. Rather than a unique product or service that flating its postpetition invoices. This “catch a vendor may provide, the mere fact that the up” scheme may be illegal, and can result in a. Sole Source Vendors vendor lacks competition creates the critical disgorgement of the inflated invoices and, vendor situation. possibly, criminal action. Some vendors may be a debtors’ only providers of essential materials or services. g. Foreign Vendors 2. Junior Lien Sales There may be no replacement vendors for sole source vendors. Even should compet- Vendors that provide their product To those vendors who do not qualify ing vendors exist, a debtor may classify from overseas may create a critical vendor as critical, a debtor may offer a junior lien certain vendors as sole source vendors situation. Offshore vendors may find that on assets in exchange for their selling on where the transition to a new vendor may the debtor cannot find a replacement vendor credit. The purpose of the junior lien is to interrupt a debtor’s operations. Where a in a timely manner. reduce the risk that if the debtor fails to pay vendor is the only sole source vendor who for the credit sale, the vendor may have readily can provide a debtor with materials h. Vendors Selling to Compa- some assets to look to for payment. How- or services, it may refuse to continue mate- nies Subject to Mass Tort ever, the junior lien sale does not pay a ven- rials or services due to the prepetition in- Claims dor’s prepetition claim. Therefore, this al- debtedness, and the debtor’s operations ternative is more risky for the vendor. could be disrupted while the debtor seeks to Over the last few years, companies that locate a substitute vendor, in excess of the used or consumed asbestos in their opera- 3. Sale of Claim amount of sole source suppliers’ prepetition tions (as opposed to manufacturers of as- claims. bestos) have been shocked to find them- A vendor that is not selected as critical selves the target of mass asbestos litigation may elect to sell its prepetition claim. Third b. Capacity Vendors and personal injury claims. parties, unrelated to the debtor, offer to pur- chase a vendor’s prepetition claim, at a dis- Some vendors of materials may be the This mass asbestos litigation has re- count. Unlike the critical vendor doctrine, a only vendors to produce such materials in sulted in scores of companies filing Chapter vendor does not have a continuing obliga- quantities sufficient to meet a debtor’s de- 11 to stay this litigation. In the asbestos and tion to sell the debtor on credit when it sells mands, even though there may be vendors mass tort cases, debtors generally have its claim to a third party. Also, unlike the that produce some of the materials. sought critical vendor status for a large por- traditional critical vendor doctrine, a vendor tion of its vendor class. selling its claim does so usually at a steep c. Quality Vendors discount. i. Small Vendors Some vendors may be deemed critical 4. Payment of All Vendors’ as they are the only vendors that provide the Those vendors whose financial sur- Claims Through Prepack debtor with certain high-quality materials. vival is dependent on the debtor paying In some cases a debtor may have customer their prepetition claim have qualified as a contracts that require the high quality mate- critical vendor. (Continued on page 11) rials.

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YOU’VE BEEN SELECTED AS A CRITICAL VENDOR, Exhibit A: Post-bankruptcy Critical Vendor Agreement NOW WHAT? NEGOTIATING [ DEBTOR ] POINTS (Continued from page 10) ______, 200_

If a debtor is contemplating Chapter TO: [Critical Trade Vendor] 11, it may negotiate with its major creditor [Name] constituencies, such as bondholders and [Address] noteholders, with hopes to reach agreement as to their treatment under a plan of reor- Dear Vendor: ganization. These pre-bankruptcy negotia- tions may result in a consensus not only as As you are no doubt aware, [DEBTOR NAME] and certain of its affiliates (“Debtors”), to bondholders and noteholders, but ven- filed a voluntary petition under chapter 11 of the United States Bankruptcy Code in the dors as well. United States Bankruptcy court for the District of ______on ______(the “Petition Date”). On the Petition Date, we requested the Bankruptcy court’s authority to F. Consider Negotiating Points of Criti- pay certain suppliers. On ______200_, the Bankruptcy Court authorized us to pay prepeti- cal Vendor Agreement tion claims of certain trade creditors that agree to the terms set forth and to be bound by the terms of the Order. The courts application of the critical vendor doctrine continues to evolve. Debt- In order to receive payment on prepetition claims, each selected trade creditor must agree ors more frequently request courts’ ap- to continue to supply goods to the Debtors based on “Customary Trade Term.” Customary proval of the critical vendor program. Trade Terms are defined as the normal and customary trade terms, practices and programs Where the doctrine is approved, courts rea- (including, but not limited to, credit limits, pricing, cash discounts, timing of payments, al- son, both the debtors and creditors stand to lowances, rebates, coupon reconciliation, normal product mix and availability and other appli- gain something. The critical vendor bene- cable terms and programs) in effect between such trade creditor and the Debtor for the period fits by receiving early payment on its prep e- prior to the Petition Date or such other trade terms that are at least as favorable as those that tition claim. The debtor and its vendors were in effect during such time. benefit by receiving needed product on credit, which may lead to a successful reor- For purposes of administration of this trade program as authorized by the Bankruptcy ganization. A vendor being deemed an es- court, the Debtors and you agree as follows: sential vendor can have a dramatic impact on the account. The credit executive is not 1. The balance of the prepetition trade claim (net of any setoffs, credits or discounts) forced to wait what may turn out years for (the “Trade Claim”) that the Debtor will pay you is $______. uncertain payment from a reorganizing debtor. But consider negotiating favorable 2. You will provide open credit terms as follows: terms including waivers before committing ______to postpetition trade credit.

3. The open trade balance or credit line that you will extend to the Debtor for shipment of postpetition goods is $______: ((a) on ______200___, or; (b) on nor- mal and customary terms on a historical basis for the period immediately before the Petition Date).

4. Payment of your claim may only occur upon execution of this letter by a duly au- thorized representative of your company and the return of this letter to the Debtor.

Sincerely [Applicable Debtor]

By:______Its:______

Agreed and Accepted by: [Name of Trade Vendor]

By: ______

Its:______Dated: ______

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on a return-of-inventory preference claim. preference period compared to an average RETURNED INVENTORY AS The court simply relied on a credit memo- of 42.68 days during the preference period. A PREFERENCE CLAIM: randum in the above amount issued by the Also, the range of time between the WHAT IS THE VALUE? creditor in reduction of its claim. The credit debtor’s payment and receipt of invoice memorandum was deemed the creditor's during the pre-preference period was 14 to (Continued from page 1) contemporaneous determination of the mar- 105 days compared to a range 21 to 77 days ket value of the returns. during the preference period. of $11,428.88. Thereafter, the creditor picked up all of the unused yarn it had pre- Another commonly cited case is from However, the court stated that the sup- viously sold to the debtor, and the debtor the bankruptcy court in the Middle District plier failed to show that the terms under credited $134,849.50 against its outstanding of North Carolina in In re American Furni- which the debtor remitted the payments indebtedness to the creditor for the returns. ture Outlet USA Inc. (American Furniture were objectively ordinary. The supplier Outlet USA Inc. v. Woodmark Originals must established that the payments were An involuntary chapter 7 petition was Inc.), which refused to base the recovery on objectively ordinary in relation to the stan- filed against the debtor within 90 days of a return-of-inventory preference claim on a dards and terms prevailing among similarly the creditor's recovery of the yarn. An order credit the creditor had issued for past-due situated companies within the relevant in- for relief was entered, and the debtor con- invoices owing by the debtor. Instead, the dustry with respect to the type of transac- verted the case to chapter 11. Thereafter, court limited recovery to the net amount, tion in which the debtor made the payment. the debtor commenced a lawsuit against the after deducting expenses, that the creditor creditor for avoidance of the debtor's pre- had realized from its commercial resale of Here, the supplier failed to demon- petition return of the creditor's yarn and the returned inventory. strate that its practice allowing the debtor to recovery of the value of the yarn. The direct how the supplier would apply each bankruptcy court held that the returns to the Other courts dealing with a return-of- payment fell within the general range of creditor were an avoidable preference for inventory preference claim have ordered the terms within the computer resale industry. which the debtor was entitled to recover the creditors to return the inventory, when con- The supplier's general manger failed to tes- liquidation value of the returns in an flicts arise as to the valuation of the inven- tify as to the industry practice concerning amount equal to $27,459. The debtor ap- tory and no clear valuation can be made. the method by which suppliers apply a cus- pealed the bankruptcy court's order, arguing tomer's payment to outstanding invoices. that the creditor should have been directed Unfortunately, there is very little case The supplier's controller testified that the to pay the fair market value of the returns law on the application of the ordinary supplier had no written policy concerning equal to the amount the creditor could have course of business and new value defenses how it would apply each payment with re- realized from reselling the returned yarn. in return-of-inventory preference cases. As spect to outstanding invoices. Rather, cus- such, to creditors faced with such prefer- tomers would remit payment direct to its The district court limited recovery on ence demand, the decision from Active bank and the bank would then inform the the debtor's return-of-inventory preference Wear Inc. v. Parkdale Mills Inc. may pro- supplier that a customer remitted a payment claim to the sums the debtor could have vide those creditors with the only way to and which invoices the payment covered. realized from a liquidation sale of the re- reduce their preference exposure. turns. The district court, relying on the The court concluded that the supplier pre-Bankruptcy Code decision of the U.S. could not rely solely on its own policy to Court of Appeals for the Fourth Circuit in meet its burden of proof. Rather, the sup- Virginia Nat'l. Bank v. Woodson (In re plier was required to produce evidence of Decker), 329 F.2d. 836 (4th Cir. 1964), COURT MAY REFUSE ORDI- industry practice concerning how suppliers noted that the recovery from the debtor apply a customer's payment to outstanding should be based on the extent to which the NARY COURSE OF BUSI- invoices to establish the general terms pre- return had depleted the debtor and its bank- NESS DEFENSE BASED ON vailing with in the industry. ruptcy estate. The yarn's value to the debtor THE METHOD USED IN AP- was the amount the debtor could have real- The supplier did not provide any evi- ized from a liquidation sale of the yarn. PLYING PAYMENT TO OUT- dence concerning how creditors apply cus- The court refused to give the debtor any STANDING INVOICE tomer's payments within the computer re- credit for any greater recovery the debtor (Continued from page 2) sale industry beside its own informal policy. derived from its disposition of the returned Thus, it failed to establish that its practice yarn, which the court attributed to the credi- was on account of an antecedent debt. of allowing the debtor to direct which pay- tor’s expertise, time, goodwill and advertis- ments should apply to which invoices fell ing. The supplier argued that even if the within the general terms prevailing in the computer resale industry. As indicated, it is important to recog- payments were preferential, the plan admin- istrator could not avoid the payments under nize that courts have employed several other methods to determine the recovery on the ordinary course of business defense. a return-of-inventory preference claim. For The supplier introduced the testimony of its example, the bankruptcy court from the general manager in support of its ordinary District of Massachusetts in In re First Soft- course defense. The general manager testi- ware Corp. entered a judgment in the fied that the debtor remitted payment to the amount of $1,500,026 against the creditor supplier on an average of 44 days after it received the invoice during the pre-

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or indirect, absolute or conditional, volun- own serves no immediate benefit IMMUNIZING PAYMENTS tary or involuntary, disposing of the to the estate in bankruptcy. 3 FROM PREFERENCE RISK: debtor’s property. THE CREDIT CARD DE- The ruling underscores that what is The inquiry is whether the transfer property of the bankruptcy estate depends FENSE? diminished or depleted the cash available on what the debtor does leading up to the (Continued from page 1) for distribution to creditors. By contrast, if preference period. Thus, if a credit execu- the debtor transfers property that would not tive is skilled at extracting payment from files bankruptcy within 90 days of making have been available to distribute to credi- the debtor through a credit card during the payment, what is the preference risk? The tors, then no preference. preference period, the Perry court will not Bankruptcy Code vests the debtor (or trus- upset that. tee if one is appointed) with far-reaching C. The Trade Relationship: Customer powers to avoid transfers of assets and Pays by Credit Card for B2B Trans- E. Common Preference Defenses not monetary transactions prior to a bankruptcy action Needed for Credit Card Defense filing. The power to avoid preferential transfers is one of the most powerful weap- In In re Perry, the vendor provided The most commonly asserted prefer- ons a trustee has. goods on terms to the debtor, a sole proprie- ences by vendors are the contemporaneous tor. The debtor paid for the credit sale us- exchange defense, the ordinary course of The Bankruptcy Code defines a prefer- ing his credit card. The debtor filed chapter business defense and the new value defense. ence expansively to include nearly every 7 liquidation within 90 days of paying the If the vendor sells on a secured basis, such transfer by an insolvent debtor 90 days prior vendor by credit card. The bankruptcy trus- as with a purchase money security interest, to bankruptcy. The purpose of the prefer- tee sued the vendor to recover the credit the vendor may have an enabling loan de- ence provision is two-fold. First, unsecured card payment. The vendor sought dismissal fense. In addition, vendors may have proce- creditors are discouraged from racing to the of the preference contending that the pay- dural defenses, including the statute of limi- courthouse to dismember a debtor, thereby ment by credit card was not property of the tations defense, standing defense and de- hastening its slide into bankruptcy. Second, estate. mand for jury trial. The trustee generally debtors are deterred from preferring certain has no duty to investigate and consider a unsecured creditors by the requirement that D. Decrease of Credit Line Not Trans- vendor’s preference defenses, as it is the any unsecured creditor that receives a fer of Property vendor’s burden to establish the defenses. greater payment than similarly situated un- secured creditors disgorge the payment so The Perry court considered the trus- As noted, the Perry court did require that like creditors receive an equal distribu- tee’s contention that payment by a credit the vendor to establish the elements of the tion of the debtor's assets. card constituted property of the estate. The preference defense. The credit card defense court found it did not: shifts the burden of proof from the vendor The debtor has the burden of proof to to the trustee. The trustee must prove as establish the following elements of a prefer- Despite the broad scope of $ 541, part of its prima facie case that the credit ence: (1) a transfer of property of the the payment at issue was not a card payment is property of the estate. debtor; (2) transfer on account of an antece- transfer of the property of the es- dent debt; (3) presumption of insolvency tate. The payment constituted F. Vendor May not be Free from Chal- within 90 days of bankruptcy filing; (4) merely a transfer from MBNA to lenge within 90 days (one year if an insider) be- [vendor]. Debtor’s estate was only fore the filing of bankruptcy; (5) that en- implicated by this transfer insofar While the Perry ruling is welcome ables the creditor to receive more than it as MNBA decreased the credit news for vendors fighting a preference, the would have received in a liquidation. allowance under Debtor’s credit vendor’s potential liability may not end card account. Since the payment with dismissal of the preference suit. The At issue in the Perry case was whether was a transfer of mere credit, and court noted the injustice to the card com- the debtor’s payment by credit card consti- did not affect the amount of li- pany, as it was substituted as a creditor with tuted a transfer of property of the estate, the quidity or property available for the vendor. While the bankruptcy court first element the trustee has the burden to distribution by the estate’s credi- would not address whether the card com- establish. tors, the payment was not a trans- pany may charge back the transaction to the fer of an interest of the debtor in vendor, the door was opened. 1. Property of the Estate property. * * * G. The Lesson for Credit Executives The Bankruptcy Code and case law At most, a debtor’s credit consti- defines property of the estate broadly to tutes merely potential wealth. The Perry court’s ruling encourages include all interests of the debtor in prop- Creditors of an estate cannot force vendors dealing with financially-strapped erty as of the bankruptcy filing. a debtor to use credit to create customers to consider payment by credit liquidity available for distribution. card, especially if the vendor senses that the 2. Transfer of Property of the It is true that creditors benefit customer may be forced to file bankruptcy. Debtor from a debtor’s credit where the The court’s refusal to find that a credit card debtor elects to purchase property The Bankruptcy Code defines a prop- or borrow funds from a credit card (Continued on page 14) erty transfer broadly to include every direct account. However, credit on its

www.bandblaw.com Fall 2006 Blakeley & Blakeley LLP www.bandblaw.com Page 14

IMMUNIZING PAYMENTS FROM PREFERENCE RISK: THE CREDIT CARD DE- FENSE? (Continued from page 13)

payment constituted property of estate, en- courages vendors to continue to sell to cus- tomers in financial difficulty.

A vendor must address a number of issues prior to accepting credit cards, such as the terms of the merchant contract, credit card software, processing the card, timing of shipments with credit card payments, fraud, privacy issues, chargebacks and the costs of the transaction. However, as noted, accepting credit cards has many advantages, including, now, a potential preference de- fense.

1. Scott Blakeley is a principal of Blake- ley & Blakeley LLP, where he prac- tices creditors’ rights and bankruptcy law. His e-mail is seb@bandblaw. com.

2. 343 B.R. 685 (Bankr. D. Utah 2005)

3. 343 B.R. at 688.

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