Seventh Circuit Deals Blow to Critical Vendor Doctrine

Originally published 1st Quarter, 2004

On February 24, 2004, the United States Court of Appeals for the Seventh Circuit issued a decision in an appeal arising out of the Kmart Corporation (Kmart) bankruptcy that may dramatically affect large and small business bankruptcy cases across the country.1 The Seventh Circuit affirmed a United States District Court's reversal of an order by the Bankruptcy Court in the Kmart bankruptcy case that had granted the debtor authority to pay in full prepetition claims of any vendor the debtor deemed critical, provided that such "critical vendor" agreed to furnish goods on "customary trade terms."2

The debtor paid 2,330 suppliers (the so called "critical vendors) a total of approximately $300 million in satisfaction of prepetition debts pursuant to the Bankruptcy Court's order, while approximately 2,000 other vendors, who were not deemed "critical" by the debtor, were not paid. As a result of the Seventh Circuit's decision, Kmart is now sending letters to the vendors whose prepetition claims were paid in full, asking them to return the payments, and the debtor will have to sue those vendors who refuse to voluntarily return the payments.

The "critical vendor" doctrine, which is routinely applied in large and small business bankruptcy cases across the country, is cited by a debtor that wishes to pay prepetition debts owed to vendors that the debtor deems to be critical to the debtors ongoing business, on the theory that such vendors would refuse to do business with the debtor post-petition unless their prepetition claims are paid in full, jeopardizing the debtor's ability to reorganize. The application of the critical vendor doctrine results in the critical vendors jumping ahead in payment priority over the other unsecured prepetition creditors, who often receive only pennies on the dollar (and sometimes nothing) on their prepetition claims.

The Seventh Circuit's Kmart decision deals two blows to the critical vendor doctrine. First, the Kmart decision calls into question the continued vitality of the critical vendor doctrine under any circumstances. While the Seventh Circuit did not affirmatively rule that the Bankruptcy Code prohibits preferential payments of prepetition claims of so called critical vendors, the decision strongly suggests that the Seventh Circuit, or at least this particular panel of the Seventh Circuit, might eventually rule that there can be no preferential treatment of critical vendors under the Bankruptcy Code. Second, the Kmart decision imposes a high burden of proof for a debtor to invoke the critical vendor doctrine, assuming that payment of prepetition debts owed to critical vendors is ever permissible under the Bankruptcy Code. This article addresses both aspects of the Seventh Circuit's ruling.

Higher Burden of Proof Imposed On Debtor

Kmart sought permission to pay immediately, and in full, the prepetition claims of all vendors that the debtor deemed to be critical. The debtor did not identify specific vendors that it sought permission to pay (as debtors often do in critical vendor motions), but instead sought an order that would grant the debtor discretion to determine which vendors were "critical." As articulated by the Seventh Circuit, the theory behind the critical vendor doctrine is that some suppliers will refuse to do business with a debtor if their prepetition claims are not paid in full, and that if the debtor cannot obtain certain merchandise that its customers are accustomed to purchasing, a debtor such as Kmart may be unable to carry on its business. Full payment to the preferred...