With a wave off small business bankruptcies looming, more business owners and entrepreneurs are going to be looking at Chapter 11 as a possible way to continue to keep their venture operating, while shedding some of the pain from the shutdowns sparked by corona virus fears.
The recent enactment of new bankruptcy protections for small businesses will lead more such companies to consider whether Chapter 11 offers them a viable method to continue operating while shedding some of the unexpected debts incurred during the virus shutdowns.
One of the practical worries that small business owners have about the process is how they will obtain inventory going forward if they declare bankruptcy. These concerns are especially prominent in retail operations, but ultimately affect any venture selling goods at any level. Simply put, if suppliers find out a bankruptcy is looming or has been filed, what is to prevent them from just refusing to do business with the bankrupt company in the future?
It’s a legitimate worry, as the straight answer is that there is no law that protects against such refusals. But Chapter 11 debtors may be able to counter by designating a “critical vendor list,” which gives financial incentives to certain suppliers to keep the chain of goods coming, despite the bankruptcy filing.
Here’s how it works: if a debtor company going in to Chapter 11 believes that it has suppliers that it can’t afford to piss off, it can designate them as a critical vendor. Once the vendor is designated and the court approves it, the debtor firm will be able to pay off the money already owed to this supplier before the filing, using revenue taken in after the filing. The entire pre-petition debt must be paid before the debtor company’s reorganization plan is confirmed by the Court (usually several months).
From the supplier’s point of view, being designated as a critical vendor has the pleasant result of getting the outstanding debt paid off, perhaps in full if things work out well, whereas they otherwise would probably be stuck with a general unsecured claim that would be lucky to see pennies on the dollar paid out.
The mechanics of creating a critical vendor list usually involve a motion to approve a roster of critical vendors that is filed immediately after the bankruptcy petition itself (one of the so-called “first day motions” in the case).
Not surprisingly, the notion of a debtor having a bankrupt debtor determine by fiat who is a critical supplier and who isn’t has the potential to create fireworks (read: opposition and litigation) in the fledgling case. Any creditor is allowed to contest the debtor’s designation, and occasionally some do. Perhaps the most famous opposition arose in the 2004 restructuring of the KMart Corp., where unsecured creditors won a ruling from the Seventh Circuit Court of Appeals in Chicago that many thought would bring about the end of critical vendor lists entirely. That didn’t happen nationwide, although it is worth mentioning that the First Circuit court in Boston has never issued a definitive ruling on the use of the procedure in Massachusetts or New Hampshire.
Companies thinking about resorting to bankruptcy protection should consider the opportunities for negotiation with suppliers that the mere possibility of a Chapter 11 and a critical vendors list provides. Because suppliers designated on the list have a much better chance of seeing money come their way, debtors may well find themselves being courted for inclusion, and may be able to take some advantage of that. For instance, an agreement to continue the business relationship for a set time in to the future, on usual terms, or even more favorable ones, can often be negotiated.
Any business owner thinking about a bankruptcy filing should sit down before pulling the trigger and decide, at least in a preliminary fashion, who their critical suppliers are. In doing so, they should be able to prove to a judge these three factors for each supplier to be included on the list:
- that dealing with the creditor is virtually indispensable to the profitable operations of the debtor;
- that a failure to deal with this supplier risks probable harm to the debtor or eliminates an economic advantage disproportional to the amount of the supplier’s pre-petition claim; and
- that there is no practical or legal alternative to payment of the claim.
By Doug Beaton
Attorney Douglas J. Beaton has practiced bankruptcy law in the Northeast for twenty six years, and is an active commentator on developments in bankruptcy practice and procedure. He can be contacted through this form: