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Editors’ Note:  The Supreme Court’s Jevic ruling last spring remains a treasure trove of bankruptcy theory, suitable for the novice bankruptcy student and highly instructional for those of us who have practiced in chapter 11 for years.  We at The Bankruptcy Cave like it so much that we will be offering a few more posts in upcoming weeks on the lower courts’ interpretation of Jevic since the spring, the continued efforts in Delaware to sidestep Jevic, and other important learning from the case.  Here, our co-editor Justin Morgan, practicing law just a few short blocks from the court that gave us the resounding critical vendor opinion in KMart, points out that while Jevic provides dicta in support of critical vendor motions, subsequent caselaw continues to put debtors through their paces when seeking to use this theory. 

In Pioneer Health Services, Inc., Chief Judge Neil Olack of the Bankruptcy Court for the Southern District of Mississippi had one of the first opportunities to apply the Supreme Court’s recent decision on critical vendor payments structured dismissals in Czyzewski v. Jevic Holding Corp.  As we discussed here at the Bankruptcy Cave after Jevic first came out, Jevic’s holding—rejecting a structured dismissal that distributed assets contrary to the Bankruptcy Code’s priority scheme—was not particularly surprising.  But Jevic went out of its way to distinguish priority-skipping structured dismissals from other priority-skipping distributions such as critical vendor payments.  We wondered how strongly courts would read Jevic’s dicta to support critical vendor theory and other so-called “doctrine of necessity” theories.  If Pioneer is any indication, not much has changed—and courts remain (rightly) critical of critical vendors.

If anything, the Pioneer opinion was less of a resounding approval of critical vendor theory than Jevic as the bankruptcy court denied the debtor’s motion.  The bankruptcy court cited established tests for critical vendor treatment while expressing general disapproval for the whole judicially-fashioned theory.  “The Fifth Circuit, at best, takes a dim view of critical vendor orders,” according to Pioneer, so apparently Jevic did nothing to brighten the picture.  Judging by the single data-point of Pioneer, then, critical vendor theory appears to be where it was before Jevic was handed down.

A chapter 11 debtor seeks to pay prepetition claims of so-called critical vendors outside the priority scheme set forth in the Bankruptcy Code because the vendor would otherwise end its relationship with the debtor causing a disproportionate impact to the debtor’s business (or so the debtor may argue). Motions to approve critical vendor payments are usually sought early in a chapter 11 reorganization.  In exchange for accepting early payment of its prepetition claim, the critical creditor usually must enter into a new contract with the debtor-in-possession, agreeing to supply product (sometimes on credit) for the balance of the case, to ensure that it can’t simply pocket the money and run.

But the facts in Pioneer, as explained by the bankruptcy court, differed significantly from the typical critical vendor situation.  On the petition date, Pioneer owed wages to three emergency department doctors at two of its hospitals.  All three doctors had executed employment agreements with Pioneer.  According to Pioneer, all three doctors had concerns about continuing to work for a hospital that owed them money, and the hospitals would struggle or close if the doctors actually quit.  Accordingly, some ten months (?!?) after the petition date, Pioneer sought approval to pay the prepetition claims of the three doctors by treating them as critical vendors.

The bankruptcy court explained that payments to critical vendors are not explicitly authorized by the Bankruptcy Code and that the standards for approving payments of critical vendors’ prebankruptcy claims are strict.  The rule set out in CoServ (an opinion representing the low-water mark in the history of critical vendor theory, in our view) requires a showing that critical vendor payments preserve the estate:

First, it must be critical that the debtor deal with the claimant. Second, unless it deals with the claimant the debtor risk the probability of harm, or, alternatively, loss of economic advantage to the estate or the debtor’s going concern value, which is disproportionate to the amount of the claimant’s prepetition claim. Third, there is no practical or legal alternative by which the debtor can deal with the claimant other than by payment of the claim.

In re CoServ, L.L.C., 273 B.R. 487, 498 (Bankr. N.D. Tex. 2002).

The Supreme Court in Jevic cited to a different rule from the Seventh Circuit, which requires “(1) the payments are necessary for a successful reorganization, (2) the disfavored unsecured creditors will be as well off with reorganization as with liquidation, and (3) the critical vendors would cease doing business with the debtor if the payments are not made.” Pioneer at 10 (citing In re Kmart Corp., 359 F.3d 866 (7th Cir. 2004)).

As the bankruptcy court explained, “Jevic suggests that CoServ’s and Kmart’s restrictive view of critical vendor payments is the correct approach.”  Accordingly, critical vendor status was denied as to any of the doctors because the evidence submitted by the Debtor “was insufficient to show that the Affected Physicians fall within any definition of critical vendors.” Pioneer at 11.  Specifically, there was no evidence that the doctors were critical in the sense of being irreplaceable, there was no evidence the doctors would actually leave if the payments weren’t made, there were other ways to compel performance of the employment contracts, and the business purpose for paying the doctors was unsound because the Debtor had not required the doctors to execute a critical vendor agreement that would assure continued performance. Though not explicit, the bankruptcy court’s analysis in Pioneer appeared to track the CoServ factors and did not explicitly analyze the Kmart factors.

Overall, Pioneer didn’t appear to distill new law from Jevic.  The bankruptcy court would have likely followed the CoServ factors with or without Jevic, and the fact that Jevic cited Kmart was not read as a rejection of the more restrictive rule from CoServ.  Furthermore, Pioneer rested in part on facts “so far outside the norm” for critical vendor motions in chapter 11 cases that the bankruptcy court rested its decision at least in part on policy concerns. Pioneer at 13.

The Supreme Court may well have intended this exact result.  A narrow Jevic decision resting only on the lack of justification in the Bankruptcy Code for priority-skipping structured dismissals would have gotten the job done in that case.  But without explaining why critical vendor payments (or first-day wage orders or roll-ups) were different, a self-described narrow Jevic opinion could have invited more questions than answers. Cf. Stern v. Marshall, 564 U.S. 462, 502 (2011) (“[W]e agree with the United States that the question presented here is a ‘narrow’ one.”).  Many in the bankruptcy bar feared such an outcome.  By explaining that the priorities of the Bankruptcy Code can be violated for legitimate bankruptcy objectives and where supported by a significant bankruptcy-related justification, the Supreme Court may have limited such challenges.  But let’s not go overboard—Pioneer reels us all in and reminds us that a critical vendor motion remains a hard argument to win, requiring detailed facts and thorough justification.

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