THE CREDITORS STRIKE BACK! REVENGE OF THE KEY VENDORS

By Stuart Koenig & Richard Macias

In a town not so far away, at a time all too close to today, one of your principal accounts will go over to THE DARK SIDE and unleash the ultimate weapon of account receivable destruction by seeking protection under Chapter 11 of THE BANKRUPCTY CODE. What can an unprotected unsecured creditor do to defend against that most feared of financial villains, the Debtor in Possession (“DIP”)? A trade creditor who acts quickly and cooperatively with the debtor can:

• Seek to have the court determine that they are critical to the successful reorganization of the debtor and convince the court to allow the debtor to pay the creditor’s pre-petition debt immediately rather than on a discounted basis when a plan is confirmed in order to retain this essential vendor during the period of reorganization.
  
• Obtain a court order that grants the creditor a post-petition inventory lien to secure payment for sales to the DIP during the reorganization period.

How do these extraordinary weapons work?

Assessing the DIP’s Business Plan

If you have been in business for more than five minutes you know that in the rare case where a debtor confirms a Chapter 11 Plan of Reorganization, you will have to wait a year or two for the privilege of receiving a distribution of pennies on your pre-petition claim.

You may be able to avoid this unacceptable scenario if you are in a position to obtain certain types of post-petition court orders designating your company as essential to the debtor’s successful reorganization. The first step is to determine whether your goods are part of the debtor’s plan for reorganizing. This requires that you take a deep breath and suppress your initial desire to use a light saber on the officers and principals of the debtor. Instead, you need to meet with them and ask blunt questions about how they plan to stay in business during the reorganization period and specifically what they are planning to use for inventory. If these discussions produce a decision that your company’s products are a critical part of these plans, you will have leverage with the debtor and the bankruptcy court to improve your situation as a creditor and to make sales to the DIP under more protected conditions as a “key vendor”.

The Necessity of Payment Rule

In all likelihood the DIP can not pay cash for new inventory and wants terms on new purchases. The first thing you need to clarify before selling more product on terms is how you will be paid for your outstanding unsecured pre-petition debt. Ordinarily, the debtor’s obligations to pay that debt are automatically stayed by the filing of the Chapter 11. Under the Bankruptcy Code the DIP is required to file a Plan of Reorganization that proposes to pay all such debt equally. In the normal course of bankruptcy that usually turns out to be a highly discounted payment. If you are a key vendor for the debtor’s reorganization, however, you may be able get better treatment under the “Necessity of Payment Rule”.

The Necessity of Payment Rule is a bankruptcy doctrine that allows the bankruptcy court to authorize the debtor to immediately pay certain pre-petition claims, under some conditions in full, if it is determined that the creditor is essential to the continued operation of the debtor. To obtain an order of the bankruptcy court authorizing the payment of pre-petition claims under the Necessity of Payment Rule, the Debtor and the key vendor must convince the bankruptcy judge of two things: first, that the key vendor’s goods or services are essential to the “continued operation and rehabilitation of the debtor…” (Ionospere Clubs, 98 B.R. 174(Bankr. S.D.N.Y. 1989)), and second, that if the pre-petition claims are not paid the key vendor/creditor will stop selling to the debtor immediately.

If you believe there is support for such a finding, you must move quickly to get the cooperation of the DIP in petitioning the court for an order determining that special circumstances exist to authorize the payment of your pre-petition claim as a key vendor under the Necessity of Payment Rule. Even before you go to court, you should be careful to assess whether the debtor has cash reserves, or other means of achieving the liquidity, to pay you. The manner in which your pre-petition debt is repaid will be subject to the debtor’s cash flow and its ability to make payments on this debt. Often this may require cooperation from the DIP’s lender as well. There are no hard and fast rules on the mechanics of repaying a key vendor debt. This will be something you negotiate with the DIP but may also depend upon your powers of persuasion with the debtor’s secured lender.

The Vendor Lien

The vendor lien is another potential option that is available to unsecured creditors who sell goods and products the DIP needs to successfully reorganize. The vendor lien is a device unsecured creditors can use to provide protection for their ongoing post petition business with the debtor. A vendor lien is exactly what the name implies. It provides a creditor, or in some circumstances a group of creditors, with secured status for sales made to the debtor in the post bankruptcy filing period while the DIP goes through the process of preparing and implementing a plan of reorganization. The tricky part of the vendor lien is obtaining the cooperation of the debtor’s post petition lender because that creditor will have a priority blanket lien to protect its DIP financing.

In a typical lending arrangement, either in bankruptcy or out, the loan documents will preclude the borrower from encumbering its assets, even with a junior lien, without first obtaining the written consent of the lender. In a bankruptcy setting, a lender is even more skittish than normal and very reluctant to permit the DIP to grant a security interest in the lender’s collateral. Much like the Necessity of Payment Rule, in order to obtain the secured creditor’s consent to the vendor lien, the supplier (and the debtor) will first need to convince the secured creditor that their product is necessary for the debtor’s continued operation and that without the protection of a vendor lien the creditor will stop doing business with the debtor.

The benefit of a vendor lien is seen primarily in the event of a conversion to chapter 7. Under the Bankruptcy Code creditors who sell to the debtor post petition are designated as administrative creditors. These administrative claims have priority above pre-petition unsecured creditors. Vendor lien holders are typically creditors holding pre-petition unsecured claims. The post petition vendor lien enables such a creditor holding the lien to secure payment on post petition sales even ahead of other administrative creditors in the event of a conversion to chapter 7.

If the lender balks, the supplier can suggest as an alternative approach, that the lender increase the debtor’s borrowing capacity and authorize COD payments on all future shipments. Because a bank that lends to a DIP does not want to increase its risk by advancing more funds to pay on a COD basis, a proposal that will allow the DIP to buy goods on terms secured by a post petition vender lien may very well be a more palatable alternative.

In a bankruptcy, unlike in the movies, the good guys don’t often win. However, if you can avail yourself of the Necessity of Payment Rule or the vendor lien, you can leap like a star cruiser into hyper space to get a place ahead of the alliance of unsecured creditors. May the creditors’ force be with you!

Richard Macias and Stuart Koenig are partners of the Los Angeles bankruptcy and creditors' rights law firm of Creim Macias Koenig & Frey LLP.

They may be reached by telephone at 213-614-1944 and by email at rmacias@cmkllp.com or skoenig@cmkllp.com.