Why Do Vendors Get Burned Twice in Bankruptcy?

How is it that vendors often get burned twice in bankruptcy? First, when the debtor commences a Chapter 11 case, and they find out that they are not getting paid so fast (if at all) for what they are owed. Second, when the case does not go as they expected and they discover that they may not get paid for goods sold during the bankruptcy case.

My intent is to dispel some of the myths about how Chapter 11 really works. One problem is that some of what debtors tell vendors technically is correct. But what technically is correct frequently does not play out that way in real life. And, what appears to be is not real when you peek underneath the hood. 

Finally, how a bankruptcy case plays out can be shaped by numerous parties—including professionals—whose interests may be very different from those of vendors.

Here are some of the myths often told to vendors by debtors and their professional advisors.

There is no need to worry about getting paid. You have an administrative claim.
Vendors often are asked to extend credit after the commencement of a debtor’s bankruptcy case because they will have an administrative claim. Creditors are told that the debtor cannot confirm (obtain approval) of a plan of reorganization without paying administrative claims in full.

Although that is true, there is no assurance that administrative claims will be paid in full. Recently, there has been an increasing number of Chapter 11 cases that have been administratively insolvent. There is no such thing as a guarantee of payment of an administrative claim.

Great News. We’ve got “DIP” financing.
Vendors see a headline or press release that a Chapter 11 debtor has obtained millions of dollars of new financing (aka “DIP” financing). Then, they are asked to take comfort and extend new credit to the chapter debtor. However, DIP financing does not necessarily add to the debtor’s liquidity or working capital. It may mean that the debtor simply has continued its pre-bankruptcy financing arrangements.

Vendors should always inquire as to how much new money the prepetition-secured lender is providing to the debtor after the petition date. If the aggregate of the lender’s prepetition and post-petition credit is no greater than the amount due to the lender as of the petition date, the vendor should be wary.

You’ll be a critical vendor.
At the beginning of a Chapter 11 case, vendors often are told by the debtor to continue shipping on open credit terms because their pre-bankruptcy claim will be treated as a “critical vendor” claim and, therefore, will be paid in full despite the bankruptcy. The bankruptcy court has the power to permit a debtor to pay pre-bankruptcy claims if, by doing so, it will help achieve the overall goal of reorganization. Typically, it is where the debtor is unable to readily obtain an essential good or service from another source.

The problem is that the debtor does not have absolute control over which vendors are granted critical vendor status. First, the debtor’s lender will demand influence over who is on the list. Then, the bankruptcy court must enter the order approving the categories and amounts of critical vendors. Finally, the creditors’ committee professionals may demand a voice in the final approval process.

Only vendors that make it through the multi-stage process end up being critical vendors. There is no alternative other than to refrain from granting post-petition credit until the debtor can confirm that the vendor has made it through the entire multi-stage process. It is the debtor’s headache to expedite it. The debtor has no ability to make a unilateral promise.

You must continue the same credit terms.
Your customer is party to a supply contract. The customer is threatening litigation if you modify credit terms. Your customer just commenced a Chapter 11 case, is demanding credit terms in accordance with the supply contract and has threatened to seek sanctions against you for violation of the automatic stay (injunction) of section 362 of the bankruptcy code if you do not comply with the supply contract.

The simple answer is that section 2-702 of the Uniform Commercial Code allows a seller to withhold goods and to stop delivery of goods except for cash despite credit terms in a supply contract when the seller discovers the buyer’s insolvency—including the commencement of a Chapter 11 case. You do not have to continue the same credit terms.

A pre-bankruptcy claim is a pre-bankruptcy claim. Pre-bankruptcy claims generally fall into two categories: (a) ones that arose from the receipt of goods by the debtor during the twenty days immediately preceding the date of bankruptcy (a “503(b)(9) claim” or a “20 day claim”) and (b) ones that arose from the debtor’s receipt of all goods and services during the period preceding the date of bankruptcy exclusive of the claims in category (a) above. Claims in category (a) have an administrative priority—meaning the same priority status as if they arose from the debtor’s receipt of the goods after the petition date.

Creditors often are solicited to sell their claims. Never sell a 20-day claim—which has administrative status—for the same price as a regular unsecured claim.

This is a reorganization case. Supporting a reorganization does not necessarily mean that you will retain a customer in the long run. Reorganization does not necessarily mean reorganization. “Reorganization” can mean an orderly liquidation in Chapter 11. It can mean a bulk sale of substantially all of a debtor’s assets in Chapter 11. Section 363 is the section of the Bankruptcy Code that authorizes such sales. 

This case is too big to fail. 
The landscape is littered with large Chapter 11s that failed or stalled. For example, Sears won approval for its Chapter 11 plan of reorganization in October 2019, but no effective date has occurred yet. Sears has not yet raised the funds to fully pay administrative expenses such as for goods delivered to its stores after the Chapter 11 filing. Sears had proposed to fill the gap in part with recoveries from preference actions (lawsuits against its own vendors to disgorge payments that they received prior to the bankruptcy).

Chapter 11 debtors are desperate for working capital; so, they always want more trade credit. And, bank lenders want a debtor to convince vendors to give it. But, what vendors are told often is the result of bankruptcy professionals telling the debtor’s management what to say to vendors in order to obtain new credit. What gets said often technically is correct. However, there is no substitute for being attentive, for experience or for being skeptical and consulting with bankruptcy counsel if necessary. 

Kenneth A. Rosen is a partner at Lowenstein Sandler.

The views expressed herein are those of the author only and are not necessarily shared by other persons at Lowenstein Sandler LP. Each case is unique. The law is subject to interpretation. Consult with your own counsel.