Critical Vendor Try Critical Merchant

Critical Vendor Try Critical Merchant

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In the wake of the Seventh Circuit's decision striking down the Kmart bankruptcy court's order authorizing the payment of pre-petition obligations owed to "critical vendors," one was entitled to wonder whether the critical vendor motion was dead.1 Two recent chapter 11 cases filed by Florida-based companies illustrate that while the concept of the "critical vendor" is not dead yet, suppliers to bankrupt customers of their products are being asked to answer the question of whether it's the customer, not the vendor, that deserves the sobriquet "critical"—in other words, the "critical merchant."

The "Sunk-cost Fallacy"

In the Kmart decision, Judge Easterbrook, writing for the Seventh Circuit, postulated that vendors would treat their post-petition customer in a manner consistent with the vendors' economic self-interest. Therefore, if post-petition payments for new goods were assured, and the vendors were able to generate a positive margin on those new goods, they would ship without regard to the debtor's pre-petition payables. To quote the court: "Firms that disdain current profits because of old losses are unlikely to stay in business." Conversely, if post-petition payments were in doubt, or no margin could be generated on post-petition shipments, the vendors would not ship and "the debtor should be liquidated post haste." Judge Easterbrook's sunk-cost hypothesis was put to the test in two recent chapter 11 cases, one involving Tropical Sportswear International, a distributor of licensed and private label apparel, and the other Winn-Dixie Stores, the operator of approximately 900 supermarkets in the southeastern United States.

The Tropical Sportswear Case

In the Tropical Sportswear case, a critical vendor motion was filed and was granted.2 At the time that the order was entered, the debtor had entered into an agreement to sell substantially all of its assets to Perry Ellis for approximately $88.5 million. The primary beneficiaries of the "critical vendor" order are the mills that produce the denim, khaki and other fabrics used to manufacture Tropical's apparel and the company where much of this fabric is cut and sewn. In approving the motion, the bankruptcy court made several critical findings including (1) it would take four to six weeks to replace the vendors, (2) the vendors would cease production and delivery of the new product without payment of the pre-petition claims, (3) the goods and services the vendors supply are unique, (4) the vendors work on slim profit margins and (5) a disruption in the supply of the vendor's goods and services would disrupt the pending sale of Tropical's business. Although the Tropical case is decidedly not a reorganization, the court ultimately concluded that the net effect on the debtor, its estate and creditors from the approval of the critical vendor payments would be positive.

[I]n a reorganization with adequate liquidity, a debtor who is willing to push back can compel its vendors to contemplate an environment in which they lose the debtor and replace it with a mass merchant as their primary customer.

Perhaps the Tropical case presents a corollary to the economic theory espoused by the Seventh Circuit in Kmart: Critical vendor payments should be allowed when they enhance the liquidation value of the debtor. Certainly the advantaged creditors recognized the leverage the pending Perry Ellis deal provided and used it to their full advantage. In their minds, the calculus must have gone something like this:

If we cut off supplies to Tropical, we may disrupt its business and give rise to a Material Adverse Change under the Perry Ellis Purchase Agreement. In that event, Perry Ellis may renegotiate the purchase price downward. We will lose some incremental recovery on our pre-petition claim and lose some incremental margin on the post-petition sales we would have otherwise effectuated. At the end of the day, however, we will more than likely be able to sell our goods and services to the reconstituted business owned and operated now by Perry Ellis. It is worth risking the relatively few dollars we would generate by going along with the program if we can cash out our pre-petition claim now. Moreover, even if the debtor calls our bluff, we can always change our minds later and ship.
The "critical vendors," being no strangers to the bankruptcy and distressed world themselves, effectively gamed the system and exacted payment of 77.5 percent of their pre-petition claims.3

The Winn-Dixie Case

Winn-Dixie's list of its 50 largest unsecured creditors reads like a who's who of the grocery supply business and includes such firms as Kraft, Pepsico, Procter & Gamble, Nestlé, General Mills and Kimberly Clark, among others.4 During the last 15 years, the grocery business in general, and the major grocery vendors in particular, have been major beneficiaries of the "critical vendor" doctrine with chapter 11 cases involving supermarket operators such as Grand Union, Bruno's and Jitney Jungle leading the way. In those cases, the major grocery vendors used the threat of pulling their high-profile brands from the debtors' shelves to leverage payments of their pre-petition and reclamation claims. In consideration of the "critical vendor" payments made in those cases, the grocery vendors agreed to continue to provide credit to the debtor to support the delivery of product on a post-petition basis. Given this history, one would have expected the Winn-Dixie filing to include a request to make critical vendor payments. Surprisingly, it did not. Although as of this writing it is still early in the case, it appears that a critical vendor motion is not forthcoming.

Is this a case where the Seventh Circuit's economic theory holds true? There seems to be a good chance that the answer is "yes," and here are some of the reasons why. In Winn-Dixie's core markets in the southeast, it tends to be the number one or two player, with Wal-Mart as the number two or three player. Unlike the vendors to Tropical who are selling commodity products (e.g., raw denim and khaki) at slim margins, Winn-Dixie's vendors are selling consumer products with substantial brand value and reasonably high wholesale margins. While Tropical is a major supplier to Wal-Mart, Winn-Dixie competes directly against Wal-Mart in more than two-thirds of its stores. Thus, the potential "critical vendors" are left with a graphic choice: Support Winn-Dixie's reorganization by doing business with it on a post-petition basis, or not do business with it, thereby increasing the likelihood, in Judge Easterbrook's words, of a liquidation "post haste." In the event of Winn-Dixie's demise, the vendors will then be left with two significant customers, one of which will be Wal-Mart. An excellent customer to be sure, but one devoted to squeezing every cent out of its vendors' margins and with the buying power to exact the most favorable pricing.

Applying the Seventh Circuit's sunk-cost hypothesis, the rational decision for Winn-Dixie's vendors would be to continue doing business with Winn-Dixie in order to generate the sales volume and margins the vendors would otherwise give up. Winn-Dixie is an excellent customer with an $800 million debtor-in-possession (DIP) financing facility in place to provide it post-petition liquidity. In a very real sense, for its vendors Winn-Dixie has become the "critical merchant."

The toy industry is another example where consumer products vendors, the major toy manufacturers, find themselves in a situation where in most markets they have only two or three significant customers: Toys 'R Us, Target and Wal-Mart. Not only does a situation like this reduce margin and volume, it ultimately reduces the opportunity of the vendor to build brand value, as doing business with the mass merchants tends to result in new, innovative and often higher margin products getting squeezed off the shelves.5 This latter point is particularly important to the branded food vendors that are constantly tinkering with sizes, packaging and formulations in order to drive additional sales and generate increases in margins.

Is There a Coup de Grace for the Critical Vendor Doctrine?

As the Tropical case demonstrates, the principle that there are critical vendors that are entitled to pre-plan payments on unsecured pre-petition payables is still alive. Perhaps Tropical represents an anomalous situation based on the leverage wielded by four vendors uniquely positioned to adversely affect the pending sale of the debtor's assets. Winn-Dixie, on the other hand, suggests that in a reorganization with adequate liquidity, a debtor who is willing to push back can compel its vendors to contemplate an environment in which they lose the debtor and replace it with a mass merchant as their primary customer. Confronting that picture, the vendors may very well find that it is the debtor who is "critical," not the vendor—a "critical merchant."


1 In re Kmart Corp., 359 F.3rd 866 (7th Cir. 2004). Return to article

2 In re Tropical Sportswear Int'l. Corp., 320 B.R. 15 (Bankr. M.D. Fla. 2005). Return to article

3 Of the critical vendors, two, Galey & Lord and Burlington Worldwide, were recently acquired out of chapter 11 cases. The other two are certainly no strangers to the process, either. Return to article

4 In re Dixie Stores Inc., et al., Case No. 05-11063 (RDD) (Bankr. S.D.N.Y. filed Feb. 21, 2005). Return to article

5 See "Wal-Mart Pinches Toys 'R' Us," International Herald Tribune (online edition) (Sept. 13, 2004). Return to article

Journal Date: 
Friday, April 1, 2005