With the commencement of a Chapter 11 reorganization comes the automatic stay and also a prohibition of the debtor’s use of cash collateral, incurring of new debt, or activity outside the ordinary course without appropriate court orders.

Operation of the debtor’s business, therefore, requires a number of orders at the outset of the case — these are called the First Day Orders. First Day Orders commonly include orders allowing for: Payment of taxes; Payment of pre-petition payroll; The Use of Cash Collateral; and/or Debtor-in-Possession financing.

During the past decade we have seen “Critical Vendor Orders” added to the list of common First Day Orders. Critical Vendor Orders are orders that allow a debtor to pay the pre-petition claim of an unsecured creditor while other creditors are not being paid. The rationale behind the original Critical Vendor Orders was that one or more vendors who supplied products or services that were essential to the Debtor’s reorganization would be unable to continue to supply the product or service without an immediate payment. The theory is that if the payment to a vendor that would otherwise fail, would allow the supply of the product that would allow the reorganization of the debtor and therefore allow all creditors to receive more than they would if the debtor failed, then the court should authorize payment to the Critical Vendor.

In the Chapter 11’s of Kmart and Fleming the courts granted First Day Orders that included “Critical Vendor Order.” Kmart’s chapter 11 counsel argued that suppliers might refuse to ship to the debtor without special protection and that without the products that customers expected the debtor would be unable to carry on and all creditors would be harmed. Kmart’s counsel further argued that the protection that it needed to afford these vendors was payment in full of prepetition claims.

Without requiring any notice or opportunity to be heard for creditors that would not be favored, without evidence that any “critical vendors” would refuse to ship (or be rendered unable to ship) without the proposed order and without any finding that the critical vendor order would result in unfavored creditors receiving more (or at least no less than if the order was not entered) the bankruptcy court granted a critical vendor order that allowed the debtor to pay those vendors that it deemed critical.

Unlike the manufacturing cases, where the debtors sought to pay a small number of vendors so that critical components for products in production could be completed and sold, in Kmart the debtor selected 2,330 of its 4,000 vendors as “critical vendors” to be paid in full: Paying pre-petition claims of approximately $300 million — Not an insignificant portion of the $2 billion of DIP financing available. By comparison the Chapter 11 plan proposed by Kmart offered the unsecured creditors, including the 2,000 vendors who were not critical vendors, approximately 10 cents on the dollar.

With the Kmart plan on the verge of confirmation (more than 14 months after the payments had been made) the District Court reversed the Critical Vendor Order, subjecting the 2,300 vendors to claims to disgorge the payments they had received as preferential transfers. An appeal was taken.

In affirming the District Court’s decision, the Court of Appeals reasoned that if vendors had shipped in reliance of a promise of payments that were not made they might have had a detrimental reliance argument, but that no such argument could be made in the Kmart case because each vendor was paid in full for its post-petition shipments.

The court further found unpersuasive arguments that payment of pre-petition obligations to critical vendors was essential to maintain the flow of product. The court noted that some of these vendors had contracts that required continued shipments and that others would ship because each new delivery produced new profit: “as long as Kmart continued to pay for new product, why would any vendor drop the account?”

The court concluded that payment of pre-petition obligations was not the appropriate way to assure payment of post-petition obligations, suggesting that the acquisition of letters of credit to guarantee payment for post-petition shipments would have been more appropriate.

We expect that critical vendor orders will still be available under appropriate circumstances. However, before a motion seeking such an order is filed counsel for the critical vendor and/or debtor’s counsel should compile the evidence necessary to build a substantial record for the critical vendor order.

The author served as lead bankruptcy counsel to terminated salaried employees in the consolidated Chapter 11 reorganization cases of the Fleming Companies – Fleming sold between $70 million and $100 million of groceries and goods to Kmart each week during Kmart’s Chapter 11 and was the recipient of the largest critical vendor payment.

Read more about how we assist clients in  Business Reorganizations under Chapter 11 of the United States Bankruptcy Code.