Caution – Extending Credit To Companies In Chapter 11 Is Riskier Than You May Be Led To Believe
A CLIENT ALERT by Tripp Scott's Charles Tatelbaum and David Ray
A headline from the Wall Street Journal’s Bankruptcy Pro stated last week “Suppliers Get Burned in Expensive Bankruptcy Cases”. It was also recently reported that business bankruptcies increased more than 70% in 2024. Many of these business bankruptcy cases involve small to medium businesses that are now struggling because of the various economic and political factors which have reduced sales and increased the costs of doing business. At the same time, many commercial and private lenders are lowering and restricting business borrowings based upon the fear of a possible business downturn.
When a business seeks protection under Chapter 11, it is almost always authorized by the bankruptcy court to continue operating its business as what is known as a debtor-in-possession. This is a legal fiction which allows the corporate debt or in bankruptcy to operate its business as a fiduciary subject to court supervision.
In such situations, there is often a need for credit to be extended by existing vendors, suppliers and subcontractors to the debtor-in-possession so that it can continue to operate. Bankruptcy law provides that credit extended to a debtor-in-possession must be paid in the ordinary course of business, but in the event of a failure or liquidation, the debt will be entitled to a top priority amongst the unsecured creditors. Because of the uncertainties of the continuing business, many creditors are hesitant to simply extend credit to a debtor-in-possession based upon a promise of timely payment and an amorphous priority in the event of liquidation.
Beginning with the first Chapter 11 proceeding for Kmart, the bankruptcy courts developed the concept known as a critical vendor which is a situation where a particular supplier of goods or services is deemed to be of critical importance to the viability and continuation of the debtor-in-possession’s operation. Upon such a finding, the bankruptcy court may authorize the debtor to pay to the creditor all or part of its pre-bankruptcy obligations on the condition that the creditor extend new and many times increased credit to the debtor-in-possession. As an inducement for the extension of this credit to the debtor-in-possession, the court can enter an order granting the creditor what is known as superpriority status. This means that in the event of a liquidation, the critical vendors’ obligations will be paid ahead of all other unsecured creditors except those that may have equal superpriority status.
Chapter 11 debtors will try to entice suppliers of goods and services into becoming a critical vendor based upon the payment of all or a portion of the pre-bankruptcy debt and the promise of the superpriority status for the credit extension to the debtor-in-possession with the promise of “you can’t lose”.
If as a supplier of goods or services is so solicited, extreme caution needs to be observed in considering whether or not to extend future credit based solely upon a critical vendor status. History has shown that under 50% of business bankruptcies are able to confirm a reorganization plan, and even those that do, do not have the liquidity and financial wherewithal to satisfy priority debts at the time of confirmation of the plan. For those that fail, it must be remembered that secured lenders and secured creditors are paid in full ahead of unsecured creditors, including those with superpriority status.
Our experience has shown that it is extremely risky to extend new and especially increased credit to a Chapter 11 debtor even with the promise of critical vendors superpriority status. Given the pressure to continue and increase sales, vendors of goods and services tend to accept the promise of “you can’t lose” at face value, which is not the case.
The members of the Tripp Scott creditors’ rights practice group have developed strategies for dealing with situations where our clients are asked to continue to extend credit to a Chapter 11 debtor-in-possession, whereby additional protections can be afforded to work to minimize the risk of a future loss in the event of an unsuccessful business reorganization.
Vendors and lenders have their own financial concerns in the current market, with many economists and financial pundits forecasting an economic downturn with increasing business bankruptcies. Providing additional goods or services to a Chapter 11 debtor is often no different than doing so to any other troubled business, and thus extreme caution needs to be observed.
