Magazine article Business Credit

The Dirty Little Secret of Critical Vendor Orders: The Hidden Preference Risk That Lurks!

Magazine article Business Credit

The Dirty Little Secret of Critical Vendor Orders: The Hidden Preference Risk That Lurks!

Article excerpt


The ruling of the United States Seventh Circuit Court of Appeals in the Kmart case, which the United States Supreme Court recently let stand, upheld the rejection of Kmart's preferred treatment of some 2,300 suppliers, so called "critical vendors" with prepetition claims exceeding $300 million. The Seventh Circuit noted that the bankruptcy court lacked the equitable power under Section 105(a) of the Bankruptcy Code, or any power under the outmoded "necessity of payment doctrine", to approve payments of critical vendors' prepetition claims. However, the Seventh Circuit did leave the door open just a little bit by suggesting that the bankruptcy court might have the power to approve the payment of critical vendors' prepetition claims under Section 363(b) of the Bankruptcy Code. Bottom line, the debtor would have to prove (a) that the critical vendors would not have done business with the debtor on a cash, deposit, or any other basis absent the payment of critical vendors' prepetition claims, and (b) absent such relief the debtor would be forced to liquidate, yielding creditors less than they would have received under a Chapter 11 plan. This will drastically limit the availability of preferential treatment for critical vendors' prepetition unsecured claims in Illinois, Indiana and Wisconsin and possibly other jurisdictions.

But that is not the end of the critical vendor saga. What about those critical vendors that previously received payment of their prepetition unsecured claims under final and nonappealable critical vendor orders? They have labored under the illusion of having escaped all risk with respect to their prepetition dealings with the debtor. The last thing these critical vendors would have anticipated is being the target of a preference suit for recovery of payments they had received from the debtor within 90 days of the bankruptcy filing.

Well folks, that illusion has been shattered by recent court rulings. The Delaware bankruptcy court, in the Hayes Lemmerz Chapter 11, and the Southern District of New York bankruptcy court, in the Bethlehem Steel Chapter 11, held critical vendors, that were paid their prepetition unsecured claims during the bankruptcy, were subject to preference risk. Not quite the deal critical vendors thought they were buying into!

Critical Vendors Are Not Immune From Preference Risk

The Hayes Lemmerz Case

On December 5, 2001, Hayes Lemmerz International Inc. and several of its affiliates filed Chapter 11 with the Delaware bankruptcy court. Prior to the bankruptcy filing, the debtors had manufactured and sold wheel and brake components for commercial vehicles. Defendant Export Corporation stored the debtors' products and, on the debtors' instruction, delivered them "just in time" to the debtor's customers.

The debtors filed a motion for authority to pay prepetition shipping and warehouse charges owing to certain critical vendors. The court approved an order that authorized the payment of critical vendors' prepetition claims conditioned on their agreement to continue to extend post-petition credit to the debtors on prepetition credit terms. Export claimed it was a critical vendor entitled to payment of its prepetition claim under the critical vendor order.

The debtors ultimately sold their business and confirmed a liquidating Chapter 11 plan. The HLI CreditorTrust was created under the plan to prosecute preference and other claims. The Trust sued Export seeking recovery of the sum of $286,385.66 that Export had received from the debtors during the 90-day preference period. Export moved to dismiss the complaint. One of Export's arguments was that the critical vendor order protected Export from preference risk. Export claimed the critical vendor order entitled it to payment of all prepetition amounts owed by the debtor, whether those amounts were received pre- or postpetition, and as such, the Trust's preference claim should be denied. …

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