BUSINESS CREDIT MAY 2005 (13080) Law Thr Secur Bankruptcy and Receivables From Shielding Your COLUMN CREDIT Customer Bankruptcy Bankruptcy Update: ough Trust Fund Point/Counterpoint Hear Bruce speakat s andA Risk: NoNeedto at CreditCongress: Related Sessions Protecting Trade Credit Congress: ed Creditors Creditors From Cry theBlues! C T National Association of Credit Management National AssociationofCredit Business Credit Business Credit HE REDIT June 14 Jun greements P e 15 UBLICA A ND TION F INANCE F OR further business, even for cash”? The Seventh Circuit’s holding in received under aconfirmed Chapter11 plan. other unsecured creditors lessthanthey wouldhave absent payment of critical vendor claims, yielding (b) th payment of their pre-petition unsecured claims, and cash, deposit orotherwise, absent the debtor’s have done business withthe debtor onany basis; the following: (a)the critical vendors wouldnot or test r ously beli area wassubpoenaed totestify, does anyone seri- credit terms) and someone from the vendor’s sales with adebtor (onevencash,deposit orletterof for critical vendors. Ifacourtapplying the d Bankruptcy Cod court’s equitablepowersunder Section 105(a)of the outdated ”necessity of payment” doctrine and the the bankruptcycourtlacked any basisunder the ing $300million. The Seventh Circuit hadruledthat stan ment for critical vendors, under the right circum- Code might beabasisfor approving preferred treat- not decide, thatSection 363(b)of the Bankruptcy N ical vendors’ pre-petition claims. P r evertheless, the Seventh Circuit suggested, butdid astic cutbackof availabilityof preferred treatment atin ROFESSIONALS I ces : ANew LeaseOnLife Critical V equired testimony from acritical vendor corrob- g itsun e d . H ebtor wouldhavebeenf eve thatth with pre-petition unsecured claims exceed- m o n the owever f Appealsr ent for some 2,300”critical vendors” willin e toappr Kmart , th Coming inJune:RiskManagement gn e salespersonwould testify e debtor must firstprove allof ess tod case, the Seventh Circuit Court ejected an ove Km o any further business art’s paym Kmart y preferred treat- endor Orders After or ced toliqui suggested a ent of crit- Kmart , ”no d ate the courtsare not bound bythe Seventh Circuit’s states o alive and well.The Seventh Circuit coversonlythe Well, ladies and gentlemen, ”critical vendor” isstill the death knell of the critical vendor doctrine. cal ven The Seventh Circuit’s harshtestfor preferred criti- T and 363(b)of the BankruptcyCode toapprove math of d ti the preferred treatment of critical vendors’ pre-peti- rence. Courts inother jurisdictions haveapproved them. And this isbyno means anisolatedoccur- tion claims and waiverof preference claims against h en paid their pre-petition claims and waivedallprefer- had threatened toturnoff the spigot unlessTropical from certaincritical suppliers, and these suppliers Tropical’s continuing toreceive goods and services ability tocon However, the survivalof Tropical’s business, and its court appr liqui Chapter 11case. Tropical Sportswearhadfileda Kmart Florida inthe States BankruptcyCourtfor the Middle District of That happened inthe recent decision of the nited pre-petition claims. appr pret itbroadly. It did not take long for courtsto r octrin eld thatithadth on un opi ce claims against them. The bankruptcy court dating Chapter11and wasseeking bankruptcy ove th cal’s payment of the critical vendors’ pre-peti- holding, the rest of the country caninter- e r d or treatment prompted some topronounce secured claims. Sothe critical vendor f Illin Kmart em oval o e d ain summ ! ebtor’s payment of critical vendors’ ois, and . Where Tropical SportswearInt’lCorporation s alivean f th e auth ate th BRUCE S.NA Pre-Conference Issue e saleo ority un e sale, wascontingent on d well,evenin th f m d er Secti ost of itsassets. THAN, ESQ. May 2005 ons 105(a) e after- $7.00 ® ®

CREDIT COLUMN

Background ment. Secured and lien creditors sit at the top of the ladder Tropical Sportswear designed, manufactured and marketed high and are entitled to payment from the proceeds of their collat- quality casual and dress-casual trousers, shorts, denim jeans eral and a general unsecured claim for any deficiency. and woven and knit shorts for men, women and boys. Tropical Administrative claims owing to creditors for their goods and marketed its products through all major apparel channels, services provided to the debtor during the bankruptcy case are including department stores, discounters and mass merchants, on the next lower rung of the priority ladder. Creditors hold- wholesale clubs, national chains, specialty stores, catalog ing lower level priority claims, such as wage, salary, benefit, retailers and via the Internet. tax and other claims are entitled to payment in a designated order of priority from the debtor’s unencumbered assets, after Tropical’s crucial suppliers included Galey & Lord, Avondale the full payment of all administrative priority claims and Mills, Burlington Worldwide and Interamericana Products before any payment or other distribution can be made to the International/Omega de Exportaciones (collectively, the debtor’s creditors holding lower priority pre-petition general ”Critical Vendors”). When Tropical filed for bankruptcy, it owed unsecured claims. Pre-petition unsecured creditors occupy the $6,518,354.50 to the Critical Vendors. The Critical Vendors had lowest creditor rung of the priority ladder and are not entitled provided Tropical with certain unique products and services to receive any distribution from the debtor until the higher that Tropical used for the productions of pants. None of the priority creditors are paid in full. Critical Vendors were bound by contract or otherwise to continue to produce and sell new product to Tropical, and Those courts approving a debtor’s pre-plan payment of pre- Interamericana was a foreign corporation outside of the bank- petition unsecured claims had relied on affidavits or testi- ruptcy court’s jurisdiction. mony from the debtor’s officer stating that the payments were necessary for the debtor’s reorganization and successful Each of the Critical Vendors informed Tropical that they would business operation, and/or were in the best interests of all halt the production and sale of new product unless Tropical paid creditors and other parties in interest. Some courts estab- 77.5 percent of their pre-petition claims, and 100 percent of lished more onerous requirements for court approval of the their valid reclamation claims, and Tropical waived all prefer- payment of critical vendors’ pre-petition claims. Virtually all ence claims against them. The Critical Vendors offered to courts conditioned critical vendor payments upon the provide 60-day payment terms and revolving credit lines if vendors’ agreement to continue extending credit to the Tropical met their demands. debtor on terms set forth in the order or motion, or based on the parties’ agreement. Tropical was in a pickle. It needed four to six weeks to replace the Critical Vendors with alternate suppliers. The vendors could However, some courts, including certain United States Circuit stop supplying critically needed goods and services to Tropical, Courts of Appeal, had denied the payment of any pre-petition jeopardizing Tropical’s business. unsecured claims prior to confirmation of a Chapter 11 plan. These courts reasoned the Bankruptcy Code does not authorize In the meantime, Tropical was pushing for court approval of a pre-plan payments to unsecured creditors. Also, such payments Bankruptcy Code Section 363(b) sale of its assets to Perry Ellis violate the general claims priority rules that require the full International or any higher successful bidder of the assets. Any payment of higher priority claims before any payment can be cutoff of goods and services supplied by the Critical Vendors made to lower priority pre-petition unsecured creditors and the threatened the sale. The alternative was a disorderly fire sale same treatment for creditors in the same class. liquidation of Tropical’s assets that would have yielded far less for creditors. In Kmart, the Seventh Circuit ruled that the ”necessity of payment” doctrine no longer applied to bankruptcy cases and The Genesis Of Favorable Treatment the equitable power granted to bankruptcy courts is not a basis For Critical Vendors for approving a debtor’s payment of critical vendors’ pre-peti- The courts had approved the debtor’s payment of critical tion claims. However, the court suggested (without deciding) vendors’ pre-petition unsecured claims during its Chapter 11, that Bankruptcy Code Section 363(b) might be grounds for the and prior to confirmation of a plan based on the ”necessity of payment of critical vendors’ pre-petition claims. However, a payment” doctrine and the bankruptcy court’s equitable power debtor seeking court approval of critical vendor payments under under Section 105(b) of the Bankruptcy Code. The ”necessity of Section 363(b) must prove that (a) the creditor would not do payment” doctrine was first enunciated by the United States business with the debtor on any terms (even for cash) if such Supreme Court before the enactment of the Bankruptcy Code payments are not made, and (b) the non-participating creditors and has been followed by many courts. Section 105(a) grants would be better off with, rather than without, the payments. the bankruptcy court the power to ”issue any order, process or Not easy to prove! judgment that is necessary or appropriate to carry out the 2005 provisions of this title”. Bankruptcy Court Approval Of Preferred Treatment Y

MA Of The Critical Vendors In Tropical Sportswear Preferred treatment for critical vendors became an exception The court approved Tropical’s payment of the Critical Vendors’ to the claims priority rules. Claims are supposed to be paid pre-petition and reclamation claims and waiver of preference based on where they are situated on the claims priority claims against them. The court has the power under Sections ladder. Claims in the same class are entitled to the same treat- 105(a) and 363(b) of the Bankruptcy Code to approve a

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CREDIT COLUMN debtor’s payment of critical vendors’ pre-petition claims where The critical vendor orders in the Tower Automotive Chapter 11 the debtor can prove that: (a) the payments were necessary to capped critical vendor payments, required advance notice of the reorganization process; (b) there is a sound business justi- the payments to, among others, Tower’s pre-petition and post- fication for the payments; and (c) the other disfavored credi- petition lenders and the attorneys and financial advisors for the tors are at least as well off by the debtor’s payments to the crit- creditors’ committee, and a certification from an officer and ical vendors than without them. Tower’s financial advisor confirming the necessity for the payments. The payments were also conditioned upon the criti- Tropical’s predicament with its Critical Vendors warranted grant- cal vendors’ agreement to continue extending their normal and ing them preferred status. Tropical, its creditors’ committee, customary trade terms, practices and programs in effect during and the Critical Vendors had negotiated the critical vendor the 120-day period before Tower’s Chapter 11 filing, or such arrangement at arms-length. other terms agreed upon with Tower.

There was also a sound business justification for the The bankruptcy court in , Inc., a liquidating Chapter 11 critical vendor payments based on their threat to halt further pending in the United States Bankruptcy Court for the Middle production and deliveries of goods and provision of services, District of , also approved the payment of critical absent Tropical’s payment of their pre-petition claims and vendors’ pre-petition claims conditioned on the vendors’ Tropical’s waiver of preference claims against them. The Critical agreement to continue supplying goods to Murray during the Vendors had no incentive to continue doing business with Chapter 11 on the same credit and other terms that were previ- Tropical based on their slim profit margins on sales to Tropical, ously in effect. Murray was a leading manufacturer and seller unless their pre-petition claims were paid and preference claims of outdoor products, including, among other products, riding against them were waived. and walk-behind lawn mowers, hand-held power equipment and snow throwers. The critical vendor payments also yielded a positive effect on Tropical, its bankruptcy estate, and the disfavored creditors. Murray’s critical vendors were the only source of tooling for a Any loss of the Critical Vendors’ goods and services jeopardized particular part that Murray needed in its manufacturing process. a sale process that was far more beneficial to Tropical’s credi- These suppliers did not have contracts with Murray and certain tors than the ensuing less orderly liquidation process. suppliers were located overseas, outside the jurisdiction of United States courts. They were free to terminate their relation- Finally, court approval of Tropical’s waiver of preference claims ship with Murray at any time, with no other suppliers available against the Critical Vendors addresses a concern discussed in a to replace them. Any interruption of supply of their goods jeop- recent article entitled ”The Dirty Little Secret Of Critical Vendor ardized Murray’s business. Orders: The Hidden Preference Risk That Lurks!” in the February, 2005 issue of Business Credit. Critical vendors were warned that Conclusion court approval of preferred treatment for critical vendors does The Seventh Circuit’s Kmart decision appeared to chill the like- not necessarily protect them from preference risk. Well, the lihood of preferred treatment of critical vendors’ pre-petition Tropical court made it clear that a waiver of preference claims unsecured claims against a debtor. However, courts in other could be part of a critical vendor arrangement. jurisdictions have continued to approve critical vendor arrange- ments. More litigation will have to ensue before the trade cred- Other Court-Approved itor community can be sure whether critical vendor arrange- Critical Vendor Arrangements ments will remain part of the bankruptcy landscape. I The Tropical Sportswear critical vendor order is not an isolated occurrence. Bankruptcy courts in other jurisdictions have also recently approved the debtor’s payment of critical vendors’ pre- petition unsecured claims. Bruce S. Nathan, Esq. is a Partner in the Critical vendor orders have been approved in bankruptcy cases law firm of Lowenstein Sandler PC in in the United States Bankruptcy Court for the Southern District New York, NY. He is also a member of of New York. That court recently approved payments of critical NACM and the American Bankruptcy vendors’ pre-petition unsecured claims in the Tower Automotive Institute. He can be reached via e-mail Inc. Chapter 11 case. Tower Automotive is a leading global at [email protected]. designer and producer of structural components and assem- blies used by every major automotive original equipment manufacturer. Tower argued for authority to pay critical BUSINESS CREDIT vendors because they were the only source of vital goods This is reprinted from Business Credit magazine, a publication of the and/or services; the critical vendors had refused to continue National Association of Credit Management. This article may not be to provide such goods and services absent payment of their forwarded electronically or reproduced in any way without written pre-petition claims; and Tower’s inability to obtain these permission from the Editor of Business Credit magazine. goods and services from other sources risked the loss of sales MA

and potential huge breach of contract claims that could be Y asserted by Tower’s customers. 2005 3