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What’s in a name? Does the label itself carry meaning? When it comes to being designated as a critical vendor in Chapter 11 bankruptcy proceedings, some would say that a name is everything. In Chapter 11 bankruptcy proceedings, creditors with the designation of “critical vendor” enjoy treatment and status exceeding that available to them outside the bankruptcy realm. The critical vendor moves to the head of the line for payment. The pre-petition unsecured claims of the critical vendor may be paid, often within days of the filing of a Chapter 11 case and may even realize a dollar-for-dollar return. What of the unfortunate creditor denied the critical vendor designation? These creditors are left to their own devices and face far different treatment from the critical vendor. They can look forward to a potentially extensive term out in the cold, and wind up receiving payment far down the line from the petition date — at only a fraction of every dollar owed. Ready to sign up for the critical vendor badge? Not so fast. Critical vendors are those vendors or suppliers a debtor identifies as essential to its continued existence. These vendors generally sell materials, services or products that the debtor requires to maintain its business operations. A lengthy and close association leads such vendors to continue serving the debtor, even as payments slow to crawl. In exchange for designation as a critical vendor and payment of its claims as administrative claims, the critical vendor usually agrees to extend credit to the debtor. The U.S. Bankruptcy Code sets out a hierarchy for the payment of creditors following the commencement of the case and the confirmation of the plan. Certain secured creditors enjoy a perch atop the payment ladder, while certain unsecured creditors linger at the penultimate rung on the ladder, superior only to the debtor’s equity holders. The goal of the code is to give equal treatment to similarly situated creditors. No code provision explicitly requires or permits the payment postpetition of the pre-petition claims of critical vendors prior to confirmation of the plan of reorganization. Critics of pre-petition critical vendor payments assert that such payments subvert the code’s system by granting preference to a class of creditors and exceeding the code’s scope. In contrast, courts that approve these payments cite both statutory and equitable authority for allowing them. Section 105(a) of the code provides that a bankruptcy court may issue “any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.” The code further provides that nothing shall preclude the court from “sua sponte, taking any action or making any determination necessary or appropriate to enforce or implement court orders or rules, or to prevent an abuse of process.” The “Doctrine of Necessity,” which originally allowed debtor-railroads to pay pre-petition debts to get supplies necessary to continued operation, was extended to other debtors. The doctrine, plus the equitable powers of � 105 (a) have been combined over time to justify recognizing the special treatment of certain critical vendors. CONTRARIAN CASE LAW Some courts have routinely blessed pre-petition payments to individual critical vendors. With today’s rising number of bankruptcy filings, however, bankruptcy courts are encountering an increasing number of requests for approval of pre-petition payment to critical vendors. Recently, some bankruptcy courts have boldly refused to grant blanket approval of such requests — including the U.S. Bankruptcy Court for the Northern District of Texas. Bankruptcy Judge Dennis Michael Lynn drew the attention of many — debtors, creditors and attorneys alike — in early 2002 when he ruled in In re CoServ that while bankruptcy courts may permit pre-plan payment of pre-petition unsecured claims, such payments should be authorized only upon a finding of “necessity” based upon a preponderance of the evidence. In CoServ, Lynn adopted a three-prong test for necessity requiring anyone seeking critical vendor status to prove: 1. the debtor’s ability to sustain business dealings with the vendor must be critical to the debtor’s ongoing operations; 2. unless the debtor maintains its business dealings with the vendor, the debtor risks the probability of harm or loss of meaningful economic advantage disproportionate to the amount of the vendor’s pre-petition claim; and 3. for the debtor to sustain business dealings with the vendor, there is no practical or legal alternative to the debtor’s payment of the vendor’s claim. Applying the test to the critical vendors proposed by CoServ, a telecommunications company, Lynn ruled that five of seven vendors did not qualify as critical vendors: including a company that installed grounding equipment, one that provided billing and collection services, a consultant, one of several companies said to “supply certain goods” to the debtor and a quasi-landlord. Apparently considering the relatively small sum at issue and the fact that the claim was payable either as a wage or an assumed contract, the court allowed the debtor’s payment to a contract employee as a critical vendor. In April 2003, in Kmart’s Chapter 11 proceeding, which was carefully observed by Wall Street and Main Street, the U.S. District Court for the Northern District of Illinois held that the bankruptcy court had neither statutory nor equitable authority to authorize pre-plan payment of pre-petition unsecured claims, even when such payments were made to critical vendors. The court in Capital Factors Inc. v. Kmart Corp. stated that “however useful and practical” these payments might be, such payments were not authorized by the Bankruptcy Code. The Kmart and CoServ cases at the very least illustrate the perils of making and relying upon assumptions in bankruptcy practice. That a court will routinely approve agreements to pay critical vendors simply cannot be assumed. It seems clear that at least for now, a name, or label, does matter, particularly that of a critical vendor. Vincent P. Slusher is a shareholder in Dallas’ Davis Munck (www.davismunck.com). He heads the firm’s bankruptcy and business reorganization section. If you are interested in submitting an article to law.com, please click here for our submission guidelines.

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