Delaware Bankruptcy Court Rules That “Critical Vendor” Status Does Not Insulate a Creditor From Preference Claims

In what may be a pivotal ruling on the issue nationwide, a bankruptcy court in the influential District of Delaware has ruled that obtaining status as a so-called “critical vendor” in a commercial Chapter 11 case does not provide a defense if the vendor is later sued for recovery of allegedly preferential payments received from the debtor just prior to the bankruptcy.

Critical Vendor Treatment

In many commercial Chapter 11 cases, the debtor will obtain goods and services from certain suppliers that are deemed essential to the ongoing operation of its business – and thus also to any effort to successfully reorganize – but that are not required (by contract or otherwise) to continue to do business with the debtor while it is in bankruptcy, or to keep the debtor on the same credit terms that it previously enjoyed. In order to induce these suppliers to continue to sell to the debtor on credit as it endeavors to reorganize and emerge from bankruptcy protection, the debtor will frequently request that the court authorize “critical vendor” treatment for such suppliers.  Such treatment customarily involves the debtor being authorized, in its discretion, to designate the suppliers that it believes to be essential to its operations, and then to pay the pre-bankruptcy balances owed to those creditors, sometimes even in full, before it pays creditors with higher priority claims under the Bankruptcy Code. In return, the vendor commits to continue to supply the debtor during the pendency of the Chapter 11 case, and generally on the same or better payment terms than applied before the bankruptcy was filed. Accordingly, obtaining critical vendor treatment is frequently the best possible outcome for suppliers to a debtor in Chapter 11, allowing them to achieve a significant or even full recovery on their pre-bankruptcy claims when they otherwise would have had a lower-priority claim that may have been paid only in small part — and months or years later — or not at all.

Critical Vendor Status as a Defense to a Preference Claim

But what happens later in the case when the debtor (in order to fund payments to creditors required under its Chapter 11 plan) or a succeeding bankruptcy trustee or creditors’ committee (seeking to accumulate funds to pay claims of lower-priority creditors) sues one of these suppliers as permitted in the Bankruptcy Code to recover allegedly preferential payments that it received over the 90 days immediately preceding the bankruptcy filing? When faced with such claims, suppliers have frequently argued that the critical vendor status they obtained earlier in the case, and the fact that their pre-bankruptcy balances were paid (even in full) as a result, serves as a complete defense to a subsequent preference claim. The crux of the argument is that the supplier received no preferential treatment because even if it had not been paid prior to the bankruptcy, it would have been paid post-bankruptcy as a result of obtaining status as a “critical vendor.”

But in Insys Liquidation Trust v. McKesson Corp. (In re Insys Therapeutics Inc.), 21-50176 (Bankr. D. Del. July 21, 2021), Delaware Bankruptcy Judge John T. Dorsey squarely rejected this argument on a motion to dismiss, ruling that authorization of critical vendor treatment for a supplier at the outset of a Chapter 11 case does “not in and of itself . . . bar a [subsequent] preference claim” to recover payments to that supplier before the bankruptcy. In Insys Therapeutics, as in most Chapter 11 cases, (1) the court’s order authorizing critical vendor treatment did not list or identify the specific vendors to be paid, leaving it in the debtor’s discretion to make those designations; and (2) payments to be made to suppliers under the order were also discretionary with the debtor, subject to negotiations with its various suppliers, and therefore not mandatory. In addition, the terms of the critical vendor order included a proviso that it did not constitute “a waiver of any claims or causes of action that may exist against any creditor.”

On these facts, and relying heavily on a 2004 decision by another Delaware bankruptcy judge, Judge Dorsey concluded in Insys Therapeutics that the extension of critical vendor treatment to the preference defendant early in the case did not automatically bar subsequent preference claims. As in the 2004 case, he noted that the critical vendor order “did not identify [the preference defendant] as a critical vendor, did not require that [the defendant’s] pre-petition claims be paid in full and did not provide that any preferential payments previously made to [the defendant] could not be recovered.” Judge Dorsey also distinguished a handful of cases in which critical vendor treatment had shielded creditors from later preference claims, noting that in those cases, the creditors either held priority claims (as opposed to general unsecured claims) that would have been paid in full under the Bankruptcy Code in any event or were granted critical vendor status in an order or approved stipulation that expressly required their pre-bankruptcy claims to be paid in full. In the present case, however, Judge Dorsey concluded that the mere fact that a creditor was authorized to obtain treatment as a critical vendor at the outset of the case, and at the debtor’s election and discretion, “[was] not in and of itself enough to bar a preference claim; something more is required.”

Critical Vendor Best Practices

Particularly following Judge Dorsey’s decisive ruling in Insys Therapeutics, and given the added weight that many bankruptcy courts place on decisions out of Delaware, suppliers to Chapter 11 debtors that obtain critical vendor treatment under the most common types of court orders plainly cannot count on that status to provide a defense if they are later sued for the recovery of pre-bankruptcy payments received during the 90-day preference period. Rather, if significant preference exposure exists, a supplier should seek affirmatively to have the court’s critical vendor order, or even a separate stipulation with the debtor submitted for court approval, include the “something more” to which Judge Dorsey referred in his opinion – that is, language that (i) requires the debtor to pay the supplier’s entire pre-bankruptcy balance in full and/or (ii) expressly provides for a waiver of any subsequent preference claims against the supplier, with the express waiver being the preferable approach. In either case, it is also important to make certain that any such language has been appropriately noticed out to all interested parties before an order is entered, and will therefore be binding on the debtor and any trustee or creditors’ committee that may later be authorized to assert such claims.