Zenith Industrial and the Critical-vendor Preference Defense Being a Critical Vendor Does Not Pay What It Used to
Critical vendors once enjoyed the ability of receiving preferable treatment over other non-critical vendors and, as many would argue, also had an airtight preference defense. However, in addition to the recent opinions on the propriety and necessary evidentiary standards for critical vendors, bankruptcy courts are now questioning the viability of the critical-vendor preference defense.
While only a few bankruptcy courts have addressed the critical-vendor preference defense, bankruptcy courts in Delaware have issued opinions rejecting the critical vendor preference defense. Understanding these opinions, and the basis for their holdings, will aid in the successful application of the critical-vendor preference defense, if one exists.
The Critical-vendor Preference Defense
The critical-vendor preference defense is based on the theory that if the debtor would not have made the preferential transfers, the critical vendor would have had a larger pre-petition debt payable under the critical vendor order. Critical vendors assert that since the bankruptcy court approved payment of their outstanding pre-petition debt, the bankruptcy court would have approved the payment of the larger amount as well.
The flaw in that theory, as demonstrated by the cases cited below, is the accompanying assumptions. These assumptions ignore the case-by-case nature of critical-vendor orders, as well as the tighter procedural and evidentiary standards established by cases like Kmart and Co-Serv. Indeed, should the critical-vendor order provide for payment based on the relatively small size of the critical-vendor claims versus the debtor's overall pre-petition debt, for example, a substantial increase of the critical vendor's outstanding pre-petition debt might have altered the bankruptcy court's willingness to grant the critical-vendor motion altogether. See, e.g., In re Zenith Industrial Corp., 319 B.R. 810 (D. Del. 2005).
The Zenith Industrial Case
In Zenith Industrial, a preference defendant asserted, as one of many affirmative defenses, that it was a critical vendor of the debtor and, therefore, protected under the previously entered critical-vendor order. The critical-vendor order at issue provided that the debtor was "authorized, but not required, in its sole discretion, to pay the pre-petition [critical-vendor claims], in the aggregate amount of up to $1 million on the terms and conditions described in the motion."
Based on the critical-vendor order, the defendant asserted that had the preferential transfers not been made, it would have received payment from the debtor in an amount equal to the preferential transfer. In support for its proposition, the defendant relied on Kimmelman v. Port Authority of N.Y. & N.J. (In re Kiwi Int'l. Air Lines Inc.), 344 F.3d 311 (3d Cir. 2003), and Official Committee of Unsecured Creditors v. Medical Mutual of Ohio (In re Primary Health Systems Inc.), 275 B.R. 709 (Bankr. D. Del. 2002). The Zenith Industrial court, however, found the critical-vendor preference defense too speculative and readily distinguished the defendant's cited support. Zenith Industrial, 319 B.R. at 814-15.
Kiwi and Primary Health
In Kiwi, a preference defendant successfully asserted that the assumption and assignment of its executory contract negated any preference action because assumption and assignment required the cure of any default. Kiwi, 344 F.3d at 321. Therefore, if the preferential transfers were not made, the order assuming the executory contracts would have mandated payment of the larger pre-petition debt. Id.
In contrast, the payments to critical vendors in Zenith Industrial were discretionary by the express terms of the critical-vendor order. Zenith Industrial, 319 B.R. at 815. Furthermore, the critical-vendor order in Zenith Industrial did not identify any specific vendors as beneficiaries, as compared to the identification of parties to the assumed executory contracts in Kiwi. Id. Upon examination, the court found the circumstances in Kiwi to be "entirely different" and distinguished it from the matter before it. Id.
The court then analyzed Primary Health, where Judge Fitzgerald authorized a debtor to pay pre-petition wage and benefits claims. Subsequently, Judge Fitzgerald held that the administrator of an employee benefits plan who received otherwise preferential payments was protected based on the aforementioned order.
The Zenith Industrial court found Primary Health inapplicable, based mostly on subsequent cases where Judge Fitzgerald herself rejected the argument that Primary Health supports a critical-vendor preference defense. Zenith Industrial, 319 B.R. at 816 (citing Vistar Corp. v. USOP Liquidating LLC and USOP Liquidating LLC v. United Stationers Inc. (In re U.S. Office Products Co.), Adv. Nos. 02-7192 and 03-50990, Tr. of Hr'g. (Bankr. D. Del. Oct. 15, 2004)).
U.S. Office Products and Hayes Lemmerz
In U.S. Office Products, both defendants were explicitly named in the critical-vendor motion and paid pursuant to the critical-vendor order. After preference actions were brought against them, the defendants asserted that Primary Health was precedent for the proposition that a critical-vendor order precluded preference liability.
As cited in Zenith Industrial, Judge Fitzgerald rejected the defendants' assertions, noting that the most significant difference was the payment of priority claims, as in Primary Health, versus general unsecured claims, as in U.S. Office Products. Zenith Industrial, 319 B.R. at 816. Since priority claims are paid prior to general unsecured claims, the Primary Health defendants were entitled to receive payment prior to general unsecured creditors, thereby making Primary Health inapplicable to non-priority general unsecured critical vendors. See Id.
After reviewing the cases cited by the defendant, the court in Zenith Industrial found the circumstances before it more similar to those in HLI Creditor Trust v. Export Corp. (In re Hayes Lemmerz International Inc.), 313 B.R. 189 (Bankr. D. Del. 2004). In Hayes Lemmerz, the court declined to apply the critical-vendor preference defense because (a) the preferential transfers were not made under the critical-vendor order, (b) the critical-vendor order was permissive, not mandatory, (c) the defendant was not explicitly named in the critical-vendor order and (d) the critical-vendor order contained no waiver of preference claims. Hayes Lemmerz, 313 B.R. at 193-94.
Based on the similarities between the facts in Zenith Industrial and Hayes Lemmerz, the court in Zenith Industrial followed Hayes Lemmerz and found the critical-vendor preference defense inapplicable. Zenith Industrial, 319 B.R. at 818-19. The court further reasoned that even if the defendant could establish through discovery that the debtor would have intended to pay the otherwise preferential transfers to the defendant through the critical-vendor order, the defendant would have still fallen short of its burden. Id. at 817. After all, the defendant would have to establish that the court would have approved payment of that increased amount, which would have increased the aggregate amount paid under the critical-vendor order by approximately 50 percent, from $1 million to $1.5 million. Id. It was mere speculation that no party would have objected and that the court would have approved of such amounts in a motion where authority for payment of such amounts was not plead. Id.
The most important consideration in analyzing the viability of a critical-vendor preference defense is the specific circumstances of the case and the available evidence.
Accordingly, the court in Zenith Industrial denied the defendant's motion for reconsideration of the order granting the plaintiff's motion to strike that affirmative defense. Id. at 819. Notably, Zenith Industrial does not preclude the critical-vendor preference defense, as its applicability is fact-intensive. Thus, a preference defendant could, theoretically, still prevail on a critical-vendor preference defense.
Bolstering the Critical-vendor Preference Defense
Based on the holdings of Zenith Industrial and Hayes Lemmerz, one manner of bolstering a critical-vendor preference defense is the express identification of the critical vendor in the critical-vendor order, along with an express waiver of preference claims. See, e.g., In re Tropical Sportswear Int'l. Corp., 320 B.R. 15 (Bankr. M.D. Fla. 2005). However, if vendors begin demanding preference waivers in critical-vendor orders, bankruptcy courts are likely to decline entry of such orders without at least a preference analysis of all potential critical vendors. Hayes Lemmerz, 313 B.R. at 194. Indeed, approval of a critical-vendor motion is discretionary—based on the facts and circumstances presented. Zenith Industrial, 319 B.R. at 817 (citing In re Just for Feet Inc., 242 B.R. 821, 824-26 (D. Del. 1999)). Bankruptcy courts are increasingly reluctant to grant such broad protections.
The most important consideration in analyzing the viability of a critical-vendor preference defense is the specific circumstances of the case and the available evidence. For example, evidence that the preferential transfer would have been paid as part of the critical-vendor payment, that no party would have objected, and that the amounts at issue are insignificant to the bankruptcy estate, might support the application of the critical-vendor preference defense. However, obtaining such evidence, instead of assertions and assumptions, will prove difficult at best.
Creating a critical-vendor preference defense during the initial stages of the case can be a difficult, fact-intensive, case-by-case matter that depends on numerous factors. Such factors include, but are not necessarily limited to, the amount of the aggregate pre-petition debt, the amount of the proposed critical-vendor payments, the amount of the alleged preferential transfers and the express terms and provisions in the critical-vendor order.
In certain cases, particularly where the debtor has few critical vendors, the critical-vendor preference defense might apply to preclude recovery under §547. Consequently, critical vendors should consider such preference issues and the language of the critical-vendor order at the beginning of the case.