A chapter 11 debtor generally may not make payments or other distributions on account of prepetition claims except through a confirmed plan of reorganization or court-authorized liquidation.  See 11 U.S.C. §1129(b)(1).  See also In re Windstream Holdings Inc., 614 B.R. 441, 451 (S.D.N.Y.2020) (“Distributions of estate assets at the termination of a business bankruptcy normally take pace through * * * a Chapter 11 plan, * * * governed by priority.”) (quoting Czyzewski v. Jevic Holding Corp., 137 S.Ct. 973, 983 (2017).  Courts have held, however, that under those circumstances where a creditor that provides goods or services that are essential to the continued viability of a business declines to have any further dealings with the debtor unless its prepetition debt is paid in full or in part, a chapter 11 debtor may settle and pay the creditors their prepetition, unsecured claims prior to confirmation of a plan.  Historically, courts that have granted critical vendor motions have based their decisions on Section 105 and the equitable “doctrine of necessity,” also known as the “necessity of payment rule.”  These courts have reasoned that departing from the Bankruptcy Code’s principal tenets of equality of treatment is necessary for the debtor to reach its goal of reorganization.

In In re CoServ, L.L.C., 273 B.R. 487 (Bankr.N.D.Tex.2002), the court recognizing that Section 105(a) on its face may be invoked only within the confines of the Bankruptcy Code, reasoned that “[t]o get from section 105(a) to the Doctrine of Necessity, the Court must find a bridge that makes application of the Doctrine of Necessity ‘necessary or appropriate to carry out the provisions of’ the Bankruptcy Code.” Id at 496–97.  CoServ constructed this “bridge” from Section 1107(a) of the Bankruptcy Code, which places a fiduciary duty on a debtor in possession to protect and preserve the debtor’s estate, including the going-concern value of an operating business. Id at 497.  “There are occasions when this duty can only be fulfilled by the preplan satisfaction of a prepetition claim” of a critical vendor. Id at 497.

In In re Kmart Corp., 359 F.3d 866 (7th Cir.2004), the Seventh Circuit recognized that Section 363(b)(1) of the Bankruptcy Code provided the possible authority for the granting of a critical vendor motion.  This section provides that the debtor “after notice and a hearing, may use, sell or lease, other than in the ordinary course of business, property of the estate * * * * ” However, even under that section, certain criteria needed to be met before a court should allow a debtor to satisfy a prepetition debt under the premise that the vendor was a “critical vendor.”  In Kmart, the court stated that the foundation of a critical vendors order is that unpaid vendors will refuse to deal with the debtor and, as a result, the debtor will not be able to continue in business. Therefore, paying such vendors is a better option for even the disfavored creditors because it will mean the debtor stays in business and is more likely to be able to pay the disfavored creditors. Id. at 872.

In In re News Pub. Co., 488 B.R. 241 (Bankr.N.D.Ga.2013), the court provided a detailed analysis of when a critical vendor motion was appropriate.  The court stated that a debtor must provide sufficient evidence that: (1) the payments are necessary for reorganization; (2) the critical vendors will otherwise refuse to do business with the debtor; and (3) that disfavored creditors will be as well off with the critical vendor order than they would have been without it. Id. at 244.  In this case, the debtor failed to establish a sound factual basis for its request to treat 16 vendors as “critical.”

Here, the debtor provided affidavits in support of its motion.  The affidavits included a chart purporting to describe why each of the sixteen vendors are critical.  These descriptions listed the goods and/or services provided by each vendor and detailed the reasons why that each particular arrangement is beneficial to debtor, and in some cases, why there might be risk or negative consequences to ending the relationship.  However, the debtor did not, for any of the vendors, provide a reason why the vendor was critical, as opposed to just beneficial, important, or preferred.  Further, the affidavits did not allege that the vendors would refuse to do business with debtor if their pre-petition debt is not paid nor that payment of a particular vendor was necessary for reorganization.

Additionally, of the sixteen vendors, seven were owed $533.64 or less, and the court was not persuaded that a creditor who is owed a relatively nominal amount would refuse to continue in a cash on delivery or cash in advance arrangement with debtor. Id. at 244-45.  For example, one of the vendors provided that gave the debtor workers who performed a range of jobs including deliveries, dock work and mail room work.  However, the debtor witness testified that he did not know whether such specialized employees could be obtained from another employment agency.  The witness stated that some of the employees were formerly employed by debtor, and also admitted that were its employees to stop working for vendor, they could at least hypothetically be re­ hired by debtor.  This evidence was found to be insufficient to support a critical vendor motion. Id. at 245.

In In re Pioneer Health Service, Inc., 2017 WL 1279030 (Bankr.S.D.Miss.), the debtor asked for permission to pay in full the prepetition, unsecured claims of three emergency room physicians.  The court denied the request.  First, it found that the debtor had not shown that it was critical that it deal with the affected physicians.  Although the debtor alleged that the physicians were irreplaceable, there was no testimony about their education, skills, training, or licensing that would support that conclusion.  That the physicians are well-liked in their respective communities did not render them critical, “as opposed to important or preferred.” Id. at *5.  Moreover, there was no evidence presented as to the efforts, if any, made by the debtor to find replacements for the physicians.

Second, the court determined the debtor had not shown that unless the payments are made, the physicians would actually leave the Hospitals.  Rather, the debtor expressed a preference to avoid the risk that the physicians would leave, “but it failed to provide any admissible evidence that they actually intend to leave.” Id. at *6.  Third, there was a legal alternative by which the debtor could deal with the physicians other than by full payment of their unsecured claims.  From the debtor’s allegations, it appeared that the physicians might be stay violators under Section 362(a)(6).  If they were impermissibly threatening to leave the hospital in order to force the debtor to pay their prepetition claims, despite being obligated to provide services under their employment agreements, the court stated that it would authorize an action against them for violations of the automatic stay. Id.

Moreover, the Court questions whether a sound business purpose justifies the critical vendor payments.  Pioneer Health proposed to pay the Affected Physicians their prepetition, unsecured claims in full without obtaining from them any commitment to continue providing medical services to patients at the Hospitals.

Id.  Finally, it noted the Committee’s concerns that allowing the critical vendor payments would open a floodgate of requests by the debtor’s other creditors for immediate payment of prepetition claims such as the prepetition wages of two hundred forty employees. Id.

In In re Windstream Holdings Inc., 614 B.R. 441, 451 (S.D.N.Y.2020), the court stated that it could authorize payment of prepetition claims on a postpetition basis pursuant to Section 363(b) and 105(a).  It explained that Section 363 authorizes a debtor to expend funds in the bankruptcy court’s discretion outside the ordinary course of business,” and that the bankruptcy court has “broad flexibility in tailoring its orders to meet a wide variety of circumstances,” as long as debtors “articulate some business justification, other than mere appeasement of major creditors, for using, selling or leasing property out of the ordinary course of business.” Id. at 456 (quoting In re Ionoshpere Clubs, Inc., 98 B.R. 174, 175-76 (Bankr.S.D.N.Y.1989)).

The court stated that additionally, to effectuate the policies and provisions of the Bankruptcy Code, the bankruptcy court was also empowered pursuant to Section 105(a), to ‘issue any order, process or judgment that is necessary or appropriate to carry out the provisions of this title.’ ”  Thus, “a Bankruptcy Court [may] authorize the payment of pre-petition debt when such payment is needed to facilitate the rehabilitation of the debtor”, a process “which “recognizes the existence of the judicial power to authorize a debtor in a reorganization case to pay pre-petition claims where such payment is essential to the continued operation of the debtor.” Id. 456-57.

The test the court espoused was slightly different from the cited in News Pub. Co.  It stated that to retain the narrowness and the exceptional quality of the necessity doctrine: (1) the vendor must be necessary for the successful reorganization of the debtor; (2) the transaction must be in the sound business judgment of the debtor; and (3) the favorable treatment of the critical vendor must not prejudice other unsecured creditors. Id. at 457.  Significantly, it stated that a vendor’s refusal to supply goods, while a factor, was not a requirement.

[The] assertion that the doctrine of necessity requires “that the vendor have refused to supply on a postpetition basis without its prepetition claim being paid” is not supported by the cases [ ] cite[d].  In re Ionosphere explained that the “doctrine permits immediate payment of claims of creditors where those creditors will not supply services or material essential to the conduct of the business until their pre-reorganization claims shall have been paid,” but nowhere in that case did the court require a formal refusal from each prepetition claimant prior to the payment of those claims.

Id. at 458.  The court approved the use of the following ten questions in establishing whether a creditor was critical:

  • whether certain specifications or contract requirements prevent, directly or indirectly, the Debtors from obtaining goods or services from alternative sources;
  • whether a vendor is a sole-source, limited-source, or high-volume supplier of goods or services critical to the Debtors’ business operations;
  • whether an agreement exists by which the Debtors could compel a vendor to continue performing on prepetition terms;
  • whether alternative vendors are available that can provide requisite volumes of similar goods or services on equal (or better) terms and, if so, whether the Debtors would be able to continue operating while transitioning business thereto;
  • the degree to which replacement costs (including, pricing, transition expenses, professional fees, and lost sales or future revenue) exceed the amount of a vendor’s prepetition claim;
  • whether the Debtors’ inability to pay all or part of the vendor’s prepetition claim could trigger financial distress for the applicable vendor;
  • the likelihood that a temporary break in the vendor’s relationship with the Debtors could be remedied through use of the tools available in these chapter 11 cases;
  • whether failure to pay all or part of a particular vendor’s claim could cause the vendor to hold goods owned by the Debtors, or refuse to ship inventory or to provide critical services on a postpetition basis;
  • the location and nationality of the vendor; and
  • whether failure to pay a particular vendor could result in contraction of trade terms as a matter of applicable non-bankruptcy law or regulation.

Id. at 445.

Windstream Holdings also held that it was appropriate for rely on the debtors’ representations and business judgment to identify critical vendors, without listing or disclosing these vendors in papers filed with the court.  It noted that reliance on debtors’ business judgment was especially appropriate considering the time and resources it would take to have the Bankruptcy Court ask, and debtors respond to, those questions for each of the 263 vendors at issue in this case, in open court.

Court supervision of each individual critical-vendor designation is not only impractical in large bankruptcies – indeed, as Judge Drain noted, the company would likely go under before such hearings could occur, – but it was unnecessary here, given the oversight of the U.S. Trustee and the creditors’ committee of both the designations and the payments, and the ability of the Bankruptcy Court to hear objections.

Id. at 452.

Where the debtors submitted a motion to the Bankruptcy Court in which it explained how it identified its critical vendors – providing both the process and substantive criteria considered in making the determinations – and provided to the U.S. Trustee and Official Committee of Unsecured Creditors with a full list of critical vendors and the matrix of payments to critical vendors, including their identities and information on the purpose of each payment, proper procedures and protections were in place.  The court noted that the process by which debtors determined their critical vendors was based on “the very questions” that the bankruptcy court typically asked debtors, the answers to which provided the “proper evidentiary framework” for making the critical vendor determination.  “While the Bankruptcy Court relied on Debtors’ representations that they accurately answered those questions outside of court, such reliance was not an impermissible delegation of authority. In fact, courts require payments to critical vendors to be “in the sound business judgment of the debtor.” Id. at 452.


Matthew T. Gensburg