Section 547(C)

The contrasting opinions set forth above most recently went head to head in the high-profile Kmart bankruptcy cases. In Kmart, the issue was addressed by the Court of Appeals for the Seventh Circuit, which affirmed a district court's reversal of a bankruptcy court's entry of a CVO. The Seventh Circuit's decision was based on both factual infirmities in the record and a holding that as a matter of law, Section 105 of the Bankruptcy Code does not authorize the entry of CVOs. Despite the anti-CVO decision, however, supporters could take heart in the fact that the Kmart decision did not address the use of other Sections of the Bankruptcy Code to justify the entry of a CVO, such as Section 363. And recently, the Supreme Court kept the Kmart decision within the Seventh Circuit, when it denied the various petitions for a writ of certiorari arising out of the Kmart decision.

Hayes Lemmerz

However, just as the CVO issue appeared to be receding from the forefront of bankruptcy law, another collateral issue arose out of the same judicial district that made the CVO famous (or, to critics, infamous). In HLI Creditor Trust v. Export Corp. (Hayes Lemmerz International, Inc.), 313 B.R. 189 (1994), the United States Bankruptcy Court for the District of Delaware addressed the issue of whether or not the existence of a CVO provides a defense to a Section 547 preference claim brought against a party treated as a critical vendor? The answer, in that particular case, was no. But as explained more fully below, the decision by no means excluded the opposite result where a properly drafted CVO, under the right set of circumstances, could povide such a defense. As a result, critics of the CVO are now faced with a related issue, that if judicially accepted, provides additional preferential treatment to those same creditors that are already being preferred under the CVO.

In Hayes Lemmerz, defendant Export Corp. moved to dismiss a preference action on account of a CVO that permitted, but did not require, the debtor to pay certain pre-petition shipping and warehouse charges. The defendant reasoned that the CVO protected its pre-petition payments that were now subject to the preference attack, and that this protection was the law of the case. The defendant also argued that because the debtor sought the entry of the CVO, its successor in interest was estopped from attacking the payments at issue as preferential.

However, the bankruptcy court disagreed. First, it noted that the CVO in this instance was permissive, not mandatory, and it did not require that the defendant's, or any other parties' pre-petition claims be paid in full. Second, the CVO did not identify any specific critical vendors, and plaintiff did not concede that any payments were made to defendant pursuant to the CVO. Third, the CVO did not provide that previously made pre-petition payments could not be recovered.

The bankruptcy court then went on to reject a previous Delaware bankruptcy court decision that protected a creditor that had received payments under an order authorizing the post-petition payment of pre-petition wages, expenses and benefits on behalf of employees against a preference attack. In rejecting this decision (Unsecured Creditors Committee v. Medical Mutual of Ohio (In re Primary Healthcare Systems, Inc., et al), 275 B.R. 709 (2002)), the bankruptcy court noted that to accept the proposition that a CVO could protect a defendant from a preference challenge for pre-petition payments made prior to the CVO's entry would be impractical. The bankruptcy court believed this was the case because acceptance of that proposition would require a bankruptcy court to assess the value of preference claims to creditors prior to the entry to a CVO to determine whether the effect of the CVO on the debtor, or the preference claims against the critical vendors at issue were more valuable to creditors. This, the bankruptcy court reasoned, was unrealistic at the early stage in the bankruptcy case when the entry of CVOs are sought. Thus, the bankruptcy court concluded that when a bankruptcy court grants permission to pay a few discreet creditors in order to keep a debtor-in-possession's business operating, “the court is not granting a complete waiver of any preference actions.” In reaching its decision, the bankruptcy court also noted that it would be ironic to hold that the entry of a CVO waived the right to pursue preference actions, when often at the same first day hearing that a CVO is entered, an interim cash collateral order is entered that preserves parties' rights to the proceeds of preference actions.

Finally, the bankruptcy court also rejected defendant's argument that its CVO defense was akin to the protection that the non-debtor party to an already assumed executory contract had from preference actions. The bankruptcy court, in dismissing this argument, noted that Section 365 expressly requires the non-debtor party to the executory contract to be made whole prior to the contract's assumption. In contrast, CVOs and the payments thereunder are not expressly authorized under the Bankruptcy Code, let alone mandated.

Supporters of the CVO and its preference defense possibilities will take heart in the fact that the Hayes Lemmerz opinion comes from a single bankruptcy court, with no binding effect over other bankruptcy courts. In addition, supporters will hang their hat on the first part of the bankruptcy court's analysis, which focuses on language of the order itself as a reason why the proposed defense fails. After all, drafting a CVO that identifies the payee, makes the payment mandatory and even waives preference claims against the subject creditor is not that difficult.

On the other hand, critics of the CVO, who it is assumed would also be critics of the so-called CVO preference defense, will note that while it is easy to draft such an order, it may not be easy to get a bankruptcy court to enter it. Specifically, to enter a CVO that compromises preference actions at an early stage in a bankruptcy case would ask the bankruptcy court to do exactly what the Hayes Lemmerz court identified as impractical, value the waived preferences against the value of the CVO. That would be asking the court to not only compare apples and oranges, but to do so blindfolded and without a scale. Moreover, critics would also point out, that to request a bankruptcy court to enter a CVO containing these additional protections would be more egregious when very few, if any, creditors that may rely on preference actions to receive a distribution would have notice of the CVO request at the time of its presentation.

Finally, it would also appear that entering a CVO that included protections against preference attacks also could be subject to great abuse. After all, if a creditor has the leverage to be preferred post-petition, arguably against the confines of the bankruptcy code, it surely has the same leverage to be preferred pre-petition. Thus, that creditor could continue to exert its leverage and insure that the payments it leveraged the debtor into making pre-petition were outside the reach of Section 547, while also receiving post-petition payments on the remainder of its pre-petition claims. This would effectively emasculate Section 547 and its purpose of equality among creditors.

Conclusion

In short, this author, while not necessarily a critic of a well thought out, factually supported CVO, does believe that the Hayes Lemmerz court reached a proper, well-analyzed decision. On the other hand, it is clear that the issue of the CVO preference defense is not dead — because as long as there are CVOs, there will be preference defendants that will attempt to utilize there existence (and the benefits they received thereunder) to gain further benefits. While allowing such preferential treatment does seem unequitable and against basic tenets of the Bankruptcy Code, it is not hard to imagine circumstances where the hectic give and play of the first days of a bankruptcy case will enable such an order to be entered. And the odds are, it is only a question of when.

In recent years, one of the hottest topics in bankruptcy law has been the use and appropriateness of critical vendor orders (hereinafter, CVOs). Critics argue that CVOs directly contradict the mandate of the Bankruptcy Code requiring equal treatment of similarly situated creditors. Even worse, critics point out, is that requests for CVOs are often presented, and the CVO entered, in the first days of a Chapter 11 bankruptcy case on shortened and limited notice to a minimal amount of creditors, days or weeks prior to the appointment of any statutory committees under Section 1102. Thus, it is often the case that the very creditors that are being discriminated against by court sanctioned preferential behavior are not given the notice and/or do not have the knowledge to allow them to appear and object to the entry of the CVO.

In contrast, supporters of CVOs argue that the CVO flows out of the principal purpose of Chapter 11 of the Bankruptcy Code: the rehabilitation of a financially distressed business. After all, if a Chapter 11 debtor loses its critical vendors, it will be unable to emerge from bankruptcy as a viable entity. Supporters of CVOs also point to a long line of case law arising out of the old federal railroad receiverships to note that while CVOs are not expressly authorized by the Bankruptcy Code, they are supported by a long line of established case law that has been part of the insolvency process for decades and cannot be ignored.

The Kmart Cases

The contrasting opinions set forth above most recently went head to head in the high-profile Kmart bankruptcy cases. In Kmart, the issue was addressed by the Court of Appeals for the Seventh Circuit, which affirmed a district court's reversal of a bankruptcy court's entry of a CVO. The Seventh Circuit's decision was based on both factual infirmities in the record and a holding that as a matter of law, Section 105 of the Bankruptcy Code does not authorize the entry of CVOs. Despite the anti-CVO decision, however, supporters could take heart in the fact that the Kmart decision did not address the use of other Sections of the Bankruptcy Code to justify the entry of a CVO, such as Section 363. And recently, the Supreme Court kept the Kmart decision within the Seventh Circuit, when it denied the various petitions for a writ of certiorari arising out of the Kmart decision.

Hayes Lemmerz

However, just as the CVO issue appeared to be receding from the forefront of bankruptcy law, another collateral issue arose out of the same judicial district that made the CVO famous (or, to critics, infamous). In HLI Creditor Trust v. Export Corp. (Hayes Lemmerz International, Inc.), 313 B.R. 189 (1994), the United States Bankruptcy Court for the District of Delaware addressed the issue of whether or not the existence of a CVO provides a defense to a Section 547 preference claim brought against a party treated as a critical vendor? The answer, in that particular case, was no. But as explained more fully below, the decision by no means excluded the opposite result where a properly drafted CVO, under the right set of circumstances, could povide such a defense. As a result, critics of the CVO are now faced with a related issue, that if judicially accepted, provides additional preferential treatment to those same creditors that are already being preferred under the CVO.

In Hayes Lemmerz, defendant Export Corp. moved to dismiss a preference action on account of a CVO that permitted, but did not require, the debtor to pay certain pre-petition shipping and warehouse charges. The defendant reasoned that the CVO protected its pre-petition payments that were now subject to the preference attack, and that this protection was the law of the case. The defendant also argued that because the debtor sought the entry of the CVO, its successor in interest was estopped from attacking the payments at issue as preferential.

However, the bankruptcy court disagreed. First, it noted that the CVO in this instance was permissive, not mandatory, and it did not require that the defendant's, or any other parties' pre-petition claims be paid in full. Second, the CVO did not identify any specific critical vendors, and plaintiff did not concede that any payments were made to defendant pursuant to the CVO. Third, the CVO did not provide that previously made pre-petition payments could not be recovered.

The bankruptcy court then went on to reject a previous Delaware bankruptcy court decision that protected a creditor that had received payments under an order authorizing the post-petition payment of pre-petition wages, expenses and benefits on behalf of employees against a preference attack. In rejecting this decision (Unsecured Creditors Committee v. Medical Mutual of Ohio (In re Primary Healthcare Systems, Inc., et al), 275 B.R. 709 (2002)), the bankruptcy court noted that to accept the proposition that a CVO could protect a defendant from a preference challenge for pre-petition payments made prior to the CVO's entry would be impractical. The bankruptcy court believed this was the case because acceptance of that proposition would require a bankruptcy court to assess the value of preference claims to creditors prior to the entry to a CVO to determine whether the effect of the CVO on the debtor, or the preference claims against the critical vendors at issue were more valuable to creditors. This, the bankruptcy court reasoned, was unrealistic at the early stage in the bankruptcy case when the entry of CVOs are sought. Thus, the bankruptcy court concluded that when a bankruptcy court grants permission to pay a few discreet creditors in order to keep a debtor-in-possession's business operating, “the court is not granting a complete waiver of any preference actions.” In reaching its decision, the bankruptcy court also noted that it would be ironic to hold that the entry of a CVO waived the right to pursue preference actions, when often at the same first day hearing that a CVO is entered, an interim cash collateral order is entered that preserves parties' rights to the proceeds of preference actions.

Finally, the bankruptcy court also rejected defendant's argument that its CVO defense was akin to the protection that the non-debtor party to an already assumed executory contract had from preference actions. The bankruptcy court, in dismissing this argument, noted that Section 365 expressly requires the non-debtor party to the executory contract to be made whole prior to the contract's assumption. In contrast, CVOs and the payments thereunder are not expressly authorized under the Bankruptcy Code, let alone mandated.

Supporters of the CVO and its preference defense possibilities will take heart in the fact that the Hayes Lemmerz opinion comes from a single bankruptcy court, with no binding effect over other bankruptcy courts. In addition, supporters will hang their hat on the first part of the bankruptcy court's analysis, which focuses on language of the order itself as a reason why the proposed defense fails. After all, drafting a CVO that identifies the payee, makes the payment mandatory and even waives preference claims against the subject creditor is not that difficult.

On the other hand, critics of the CVO, who it is assumed would also be critics of the so-called CVO preference defense, will note that while it is easy to draft such an order, it may not be easy to get a bankruptcy court to enter it. Specifically, to enter a CVO that compromises preference actions at an early stage in a bankruptcy case would ask the bankruptcy court to do exactly what the Hayes Lemmerz court identified as impractical, value the waived preferences against the value of the CVO. That would be asking the court to not only compare apples and oranges, but to do so blindfolded and without a scale. Moreover, critics would also point out, that to request a bankruptcy court to enter a CVO containing these additional protections would be more egregious when very few, if any, creditors that may rely on preference actions to receive a distribution would have notice of the CVO request at the time of its presentation.

Finally, it would also appear that entering a CVO that included protections against preference attacks also could be subject to great abuse. After all, if a creditor has the leverage to be preferred post-petition, arguably against the confines of the bankruptcy code, it surely has the same leverage to be preferred pre-petition. Thus, that creditor could continue to exert its leverage and insure that the payments it leveraged the debtor into making pre-petition were outside the reach of Section 547, while also receiving post-petition payments on the remainder of its pre-petition claims. This would effectively emasculate Section 547 and its purpose of equality among creditors.

Conclusion

In short, this author, while not necessarily a critic of a well thought out, factually supported CVO, does believe that the Hayes Lemmerz court reached a proper, well-analyzed decision. On the other hand, it is clear that the issue of the CVO preference defense is not dead — because as long as there are CVOs, there will be preference defendants that will attempt to utilize there existence (and the benefits they received thereunder) to gain further benefits. While allowing such preferential treatment does seem unequitable and against basic tenets of the Bankruptcy Code, it is not hard to imagine circumstances where the hectic give and play of the first days of a bankruptcy case will enable such an order to be entered. And the odds are, it is only a question of when.