Lessors and Bankruptcy: A New Look at Critical Vendor Payments in Chapter 11 Cases

Robert S. Bernstein, Esquire
Kirk B. Burkley
Bernstein-Burkley, P.C.

This article appeared in LJN’s Equipment Leasing Newsletter , June 2003.
An earlier version appeared in the July 2002 issue of Equipment Leasing Today.

Obtaining the authority to make Critical Vendor payments in Chapter 11 Bankruptcy is becoming more “critical” than ever in the early stages of a bankruptcy case. Bankruptcy proceedings are supposed to be fair and reasonably predictable. However, the fair and predictable system of who gets what and in what order is becoming a lot less clear due to recent high profile cases involving Critical Vendor payments in Chapter 11.

Critical Vendor payments fall under the Necessity of Payment Doctrine, also referred to as the Rule of Necessity, which basically says that because rehabilitating a struggling business is the fundamental purpose of Chapter 11, the courts can look first at which creditors are essential to the bankrupt’s business. These “Critical” creditors get paid first to avoid a disruption in service, while creditors with greater or equal priority interest just have to wait in line and hope that there is something left over after the Critical Vendors are paid.

Similarly, whether, and to what extent, a lessor will receive delinquent payments and/or will have the lease terminated by the debtor often depends on whether the lease arrangement is considered important to the reorganization process. An understanding of the bankruptcy process can make the difference between losing out completely in a bankruptcy or at least being treated fairly during the proceedings.

The rules governing bankruptcy can be complicated, especially business reorganizations under Chapter 11, but there are some easily understood basics. Among them is the Bankruptcy Code’s preference for grouping similar creditors together and paying the members of the group fairly as compared with each other. The general scheme of distribution under the Bankruptcy Code has secured creditors getting the value of their collateral, then the expenses of administering the case are paid, then unsecured claims with priority (like those for back taxes or wages, for example) must be paid. Next, if there is anything left over, the general, unsecured creditors share that amount on a pro rata basis until paid in full. Finally, and only after all other creditors have been paid do equity holders get paid.

The general scheme of distribution and the Critical Vendor payment scenario was played out recently in the well-publicized bankruptcy of the retail giant Kmart. On the very day Kmart’s Chapter 11 petition was filed, it sought and received, as part of its “first day orders,” authority to pay hundreds of millions of dollars to unsecured creditors which Kmart urged were critical to the company’s ability to reorganize. On appeal, the District Court reversed the ruling and ordered Kmart to recover the improper payments and the Seventh Circuit affirmed. In fact, the Kmart appeal resulted in the debtor was forced to seek the return of millions of dollars from the Fleming Companies, which ultimately caused Fleming to file its own bankruptcy!

Notwithstanding the Seventh Circuit’s Kmart decision, Critical Vendor payments are not uncommon. Chapter 11 debtors frequently must deal with situations where failure to make immediate payment could destroy their ability to reorganize. For example, it may be essential to maintain a workforce that is committed to a financially struggling business, or perhaps payment to consumers for returns or warranties is necessary to ensure continued customer confidence. The justifications for making payments to persons who would otherwise take last (or at least later) are unlimited, and they are all supported by the fundamental purpose of Chapter 11 – to rehabilitate a struggling business.

At first blush, this Doctrine might seem irrelevant to equipment lessors, because of the peculiar manner in which the Bankruptcy Code deals with leases. Lessors usually will not know how their claims will be classified until some time later in a bankruptcy case when the debtor makes its decision about whether it will assume or reject its leases. The Necessity of Payment Doctrine has very real consequences, however, because at the very beginning of the case it disrupts the balanced, orderly treatment of creditors set out in the Bankruptcy Code. If a Critical Vendor motion is granted, and the debtor is permitted to make substantial payments to unsecured creditors, lessor’s essentially lose the protections granted them by the Bankruptcy Code and must get in the back of the line.

The Doctrine is not completely without merit. Conceptually, most everyone agrees that successful reorganization is preferable to liquidation, and this often forms the basis for requests that Critical Vendors be paid. Furthermore, avoiding disruption of service in the beginning of the case may turn out to be beneficial to all creditors by allowing the debtor to jump-start its business and make a greater distribution at the end of the case.

But there are problems as well, including an inherent sense of unfairness and unwarranted dissipation of estate assets. Unsecured creditors, who have no rights in any property of the debtor, and who normally take last, can extort payment of their pre-petition claims by simply refusing to do business with the debtor unless they are paid. Lessors, on the other hand, must sit by for 60 days (or longer) while the debtor contemplates whether the lease is advantageous. If it is, the debtor can compel the lessor to perform through assumption (the debtor deciding to accept the lease as a post-bankruptcy obligation). Granted, if the debtor attempts to assume the lease, all defaults must be cured, but there is certainly a legitimate argument that unsecured creditors should not receive a similar benefit without the burdens the Bankruptcy Code imposes on lessors.

A more glaring problem stems from the Bankruptcy Code itself, which could easily be read to make no allowance for payments out of the ordinary, statutory scheme. After all, the Bankruptcy Code carefully sets out how creditors are classified as secured or unsecured. Then, with equal care, the Code singles out some of the latter group for priority treatment. Within any of these groups, the Bankruptcy Code expressly requires that they be treated similarly; unwarranted discrimination is simply not allowed.

To add to the uncertainty, the courts have found ways to interpret the Bankruptcy Code to allow these so-called critical vendor payments, with varying degrees of flexibility. One court recently authorized critical vendor payments so that the debtor could “realize the possibility” of successful reorganization, a view that apparently prefers the underlying concept of Chapter 11 to its substantive provisions. Others take a more hard line approach, as a Texas bankruptcy court did, requiring the debtor to specifically demonstrate the necessity of payment and a material benefit to the reorganization effort. That court also required that there be no legal or practical alternative to payment of pre-petition indebtedness. More recently, a Pittsburgh bankruptcy court found that brewing companies supplier met the standards of being a critical vendor because it was the only company that supplied the debtor’s unique aluminum bottles.

This strict approach certainly affords greater protection to the many parties to a bankruptcy case, including lessors, who have not been singled out as particularly important to the reorganization process in the early days after the bankruptcy is filed. These early decisions carry with them sometimes irrevocable consequences.

Obviously, if unsecured claims are paid early in the case and the attempt to reorganize nevertheless fails, necessitating liquidation, lessors and non-critical vendors will receive even less than they would have, had the Critical Vendor payments not been made. A recent study concluded that this is occurring at alarming rates in New York and Delaware, a favored venue for large, corporate bankruptcies. In Delaware, where reorganization plans are often negotiated before the bankruptcy is filed and move swiftly to confirmation, over half of the companies studied failed to thrive, necessitating a second bankruptcy, liquidation, or distress merger within five years of emerging from bankruptcy.

There are other, less obvious, ways that satisfaction of a Critical Vendor’s pre-petition claim could have a lasting effect on the bankruptcy. If the creditor demands, and the court approves, this “super-priority” payment to trade vendors, the debtor may have insufficient cash to satisfy other claims that must be paid, including the payment of §365(d)(5) payments (required post-petition lease payments) or the cure amounts on assumed leases. Trade creditors could also insist, in lieu of immediate payment, that their post-petition dealings with the debtor be secured by liens on the debtor’s property and, additionally, that those liens also cover pre-petition debts. By cross-collateralizing the pre-petition debts, an unsecured creditor in this scenario would not only get superior treatment in the bankruptcy case, but also the ability to foreclose on the debtor’s property – property that would have been available to unsecured creditors generally – if the bankruptcy fails.

In any bankruptcy case, the Necessity of Payment Doctrine is, at its core, a gamble. Assuming affected parties have the opportunity to make an informed decision about critical vendor payments (which Kmart and other cases demonstrate may not always be possible), those affected parties may acquiesce to the payments. Most likely, the acquiescence would be in the belief that the odds of greater payment later in the case are better than would be had under rigid adherence to the Bankruptcy Code’s payment scheme. The risks are even higher, however, when Critical Vendor issues are presented to the court along with other first day orders, when they may be decided even before other parties receive notice of the bankruptcy. Careful monitoring of the case from its inception, along with active participation, is imperative to ensure your ability to be paid is not jeopardized. Unfortunately, there are times even lessors with substantial relationships with a debtor are not treated among the largest unsecured creditors who generally receive notice of the presentation of first day orders. Where notice is available, lessors should consider whether opposing these critical vendor payments is in their interests.

In the end, whether notice is available or not, and whether these payments are opposed or not, lessors can take a lesson from those creditors who exert their influence in a bankruptcy case. Bankruptcies are risky enough that any leverage can add a few points to the probabilities that a lessor will be treated more fairly.

Robert S. Bernstein and Kirk B. Burkley of Bernstein-Burkley, P.C. in Pittsburgh, PA practice in the areas of Bankruptcy and Creditors’ Rights and can be reached at mail@bernsteinlaw.com.

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