Critical Vendor Orders: Boon or Bane in Preference Cases?

When a company files for bankruptcy protection, its vendors risk not getting paid for outstanding invoices, and getting sued by the estate for return of payments received shortly before the petition date. Vendors may also have concerns about continuing to do business with the debtor. In order to address some of these issues, a vendor may be able to persuade the debtor to seek a court order providing that it is “critical” to the debtor’s ongoing operations. Such a “critical vendor order” protects the vendor by allowing the debtor to pay most or even all of its outstanding invoices, as well as providing some assurance of payment for ongoing sales. What these orders very often do not provide is protection from so-called “preference” claims for recovery of amounts paid to the vendor during the 90 days prior to bankruptcy.

This result may seem somewhat counter-intuitive, and has led vendors to argue that a critical vendor order should protect them from preference liability. The idea is that if the invoices paid during the preference period had remained unpaid, the debtor would have paid them pursuant to the critical vendor order instead. Payments under the critical vendor order cannot be recovered by the estate, so the existence of the critical vendor order should preclude recovery of payments that the debtor happened to make during the preference period. Unfortunately for vendors, bankruptcy courts have generally disagreed with this proposition. Among other reasons, courts have stated that it is too speculative to assume the critical vendor order would have been approved if it had also provided for payment of the additional preferential amounts, particularly due to the increased risk of objections by other creditors. What this does suggest is that a vendor might be able to address the problem by requiring appropriate provisions in the critical vendor order itself. Given the increasing difficulty of obtaining critical vendor orders generally, however, it remains unclear whether a court would approve such provisions.

Another problem triggered by critical vendor orders is that invoices which might otherwise have provided a partial defense to preference claims may no longer do so. Bankruptcy law provides that “new value” (i.e. goods or services) provided to the debtor subsequent to receipt of a preference payment will generally decrease the liability of the vendor. The caveat is that this “new value” must generally remain unpaid, or at least be paid via other recoverable transfers. So payments made pursuant to a critical vendor order may decrease the amount of a vendor’s new value defense. Nonetheless, at least one bankruptcy court examining this issue has held to the contrary. Based upon an analysis of applicable statutory language, in an unpublished decision, a bankruptcy court in Tennessee held that post-petition critical vendor payments should not deplete a vendor’s new value defense. See Phoenix Restaurant Group, Inc. v. Proficient Food Co. (In re Phoenix Restaurant Group, Inc.), 2004 WL 3113719, *13 (Bankr.M.D.Tenn.). Under this rationale, even if a critical vendor order will not protect a vendor from preference liability, at least it may not reduce the vendor’s subsequent new value defense. As there does not appear to be any higher court case-law on this exact issue, it may be worthwhile to consider this argument in appropriate situations.