Magazine article Business Credit

Getting Paid Now and in Full-In Bankruptcy: The Necessity Doctrine in Action

Magazine article Business Credit

Getting Paid Now and in Full-In Bankruptcy: The Necessity Doctrine in Action

Article excerpt

ONE OF THE NOTED EFFECTS OF CHAPTER 11 BANKRUPTCY proceedings is that vendors can suffer long delays before receiving payment on their prepetition unsecured claims. These same vendors often find that the distribution on their unsecured claims is far less than the amount owed. Indeed, it is not uncommon for vendors to be paid through a confirmed plan of reorganization with a debtor's stock. Does a vendor in this situation have any recourse?

On occasion, a vendor may find that the product or service it provides a Chapter 11 debtor is essential and is key to the debtor's continued operations. The uniqueness of the product or service may give such a vendor leverage in negotiating post-bankruptcy sales. In this situation the debtor may request that the court allow it immediately to pay the vendor's prepetition claim in the first days of the bankruptcy, in exchange for the vendor committing to sell to the debtor post-bankruptcy. This article will discuss how courts allow early payment of certain vendors' pre-bankruptcy unsecured claims, in limited situations, under the Doctrine of Necessity. Stated simply, the Doctrine of Necessity says that the debtor needs the vendor's product or service in order to reorganize its finances.

The Necessity Doctrine

A fundamental principle of bankruptcy is equal treatment of similarly situated creditors. This is especially true when it comes to payment on creditors' prepetition claims. In bankruptcy, creditors can be paid on their unsecured claims only through a confirmed plan of reorganization or court-authorized liquidation.

The Bankruptcy Code is straightforward-a creditor holding an unsecured, non-priority claim is not to be favored by a debtor, except under very limited circumstances. Courts have carved an exception to this general rule and labeled it the Necessity Doctrine. Under the doctrine, a debtor may pay certain prepetition claims, with court approval, at the commencement of the bankruptcy case where it can be established that payment of those claims will help to stabilize the debtor's business without significantly harming any party. The payment of these claims is to induce creditors to continue supplying key goods and services post-bankruptcy, which will enable-or be necessary for-a debtor to rehabilitate its finances.

Tenneco recently had occasion to examine the Necessity Doctrine. Tenneco manufactured corrugated containers. Its customer, the Debtor, distributed packaging products. The Debtor also operated two related companies, a plastics manufacturer and printer. The three companies formed one of the largest packaging manufacturers, printers and distributors in the state of California.

Tenneco supplied containers pursuant to the Debtor's purchase orders, shipping the packaging to the Debtor who then distributed the packaging and took a markup on the sale price. Tenneco was the Debtor's largest vendor, and the source of significant revenues.

Notwithstanding the profitable trade relationship with Tenneco, the Debtor was unable to satisfy its secured obligations and, along with its two related companies, was forced to file a Chapter 11 petition. The Debtor needed Tenneco's product to continue operations. At the time of the bankruptcy filing, the Debtor had a large backlog of orders for Tenneco to manufacture.

The Debtor claimed it would not survive if Tenneco severed its business relationship with the Debtor. The loss of Tenneco's product would affect the ability of the Debtor, as well as its two related companies to operate.

The Agreement

For Tenneco, the account had been profitable. In order to continue operations, the Debtor was in immediate need of Tenneco's product. Tenneco made certain demands before it would agree to continue to manufacture for the Debtor: immediate payment on its prepetition claim and waiver of any preference claims. The Debtor wanted a commitment from Tenneco to continue to manufacture. …

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