If your goods or services are considered essential for the reorganization of a business in Chapter 11, you may receive a critical vendor order from the Bankruptcy Court. This means the debtor filed a motion with the bankruptcy court to request your business be given critical vendor status and arranged for payments upon specific terms, and your invoices will be considered an administrative expense of the bankruptcy.
What are the risks and rewards of such an arrangement? It's important to understand your rights as a creditor to a bankrupt client. First, let’s start with the basics:
What Is a Critical Vendor?
The term “critical vendor” does not appear in the U.S. Bankruptcy Code because it is a concept that bankruptcy courts have created over time. In short, a critical vendor is a creditor that is so vital to a debtor’s operations that the dissolution of a business relationship would make reorganization under Chapter 11 impossible.
You can become a critical vendor in one of two ways:
- First, the debtor or the trustee of the bankruptcy estate may deem the goods and services you provide to the debtor critical to its reorganization and seek authority from the bankruptcy court to pay your pre- and post-petition claims as an “administrative expense.” When this occurs, every invoice you submit will become an administrative expense of your client’s bankruptcy proceedings.
- Second, you can seek critical vendor status by convincing a debtor to file a motion on your behalf. You may be able to prove that you are a critical vendor by withholding goods or services, but you must be careful not to violate automatic stay orders or breach contractual obligations during bankruptcy. Any motion or agreement is subject to the approval of the bankruptcy court.
In either case, maintaining good relationships with your clients and providing unique goods and services are both good strategies for becoming a critical vendor.
If your client and the bankruptcy court identify you as a critical vendor, you will receive a critical vendor letter and a vendor agreement. Usually, the bankruptcy court pre-approves these agreements, and in most cases, it is in your best interest to accept the agreement.
Payment Terms and Credit Terms
Typically, your client will pay any of their debts in a lump sum soon after the bankruptcy court approves your critical vendor agreement and enters an order. Otherwise, your client may want to make payments over time. You should speak to an attorney to weigh the risks and rewards of the debtor’s offer.
Remember that you will need to continue providing goods and services to the debtor under the terms of the critical vendor agreement or terms that are more favorable to the debtor. The critical vendor agreement applies even if you do not believe the debtor will maintain financial viability or continue operating under Chapter 11.
Can I Negotiate?
If the debtor agrees to pay 100% of your administrative expense claim in a lump sum, there is no reason to negotiate, and you likely won’t be able to change the terms. If you are willing to accept less than 100%, however, you may be able to negotiate the amount and timing of payments and create a clause that reinstates your rights as a creditor if the debtor defaults.
Generally, critical vendor agreements are non-negotiable because they are pre-approved by the bankruptcy court, but you should always speak to an attorney about your rights and legal options because you may be able to redline the agreement.
The Pros of Critical Vendor Status
Serving as a critical vendor to a company filing for Chapter 11 bankruptcy elevates your status above other creditors and means that you will likely get paid for any outstanding balances as a condition for continuing to provide critical goods or services.
Other “non-critical” creditors meanwhile may only recover a percentage of debts owed, depending on whether the debt is secured or unsecured. And they will have to wait for months or even years for the reorganization and repayment plan to be approved by the bankruptcy court before recovering a dime of the debt owed.
The Risks of Critical Vendor Status
Accepting a critical vendor agreement is generally wise because you will receive at least some of what you are owed. Without a critical vendor agreement, you could wind up with pennies on the dollar. However, you should be aware of potential risks:
- Releases. If your prepetition claim is not paid in full, you may be required to give up certain rights to pursue further claims against your bankrupt client. Consult an attorney to check the critical vendor agreement for releases.
- Not protected from preference actions. Critical vendor status will not protect you from litigation by the debtor or trustee of a bankruptcy estate to recover payments made to you immediately preceding the filing of the bankruptcy petition. These are called preference actions or clawbacks and are permitted by the U.S. Bankruptcy Code.
- Strings attached. Once you enter into an agreement, you are bound to its terms. Make sure you can operate profitably within those terms and have the financing or cash flow to pay for the goods or services.
- Appellate risk. When Kmart filed for bankruptcy, the company petitioned the bankruptcy court to designate more than 2,300 vendors as critical. A creditor that did not receive critical vendor status appealed the bankruptcy court’s orders, and an appellate court reversed the decision and required the critical vendors to return payments received.
Can I Be Compelled to Serve as a Critical Vendor?
Unless there is an enforceable contract that says otherwise, a debtor in bankruptcy cannot force a creditor to continue to provide goods and services; however, you may be required to continue to provide goods or services if the contract is an executory contract or risk being in breach.
