Speculative Right to Payment Under Critical Vendor Order Is Invalid Defense Against Preference Liability

In Zenith Industrial Corp. v. Longwood Elastomers, Inc. (In re Zenith Industrial Corp.), the United States Bankruptcy Court for the District of Delaware held that a debtor's vendor could not defend an action by the debtor to avoid pursuant to section 547 of the Bankruptcy Code payments made prepetition by the debtor to the vendor on the basis that the vendor would have been a "critical vendor" under an order authorizing the debtor to make certain payments of prepetition claims to its critical vendors had the vendor not been paid prepetition within the preference period.

Section 547 of the Bankruptcy Code

Section 547 of the Bankruptcy Code allows a debtor in possession to avoid (and then recover "for the benefit of the estate" pursuant to section 550 of the Bankruptcy Code) "preferences," which are defined as transfers of property, including payments, made to or for the benefit of a creditor on account of an antecedent debt while the debtor was insolvent in the 90 days prior to the commencement of the debtor's chapter 11 case (one year for insiders) and that allow the creditor to recover more than it would in a hypothetical chapter 7 liquidation of the debtor.

Background

On March 12, 2002, Zenith Industrial Corporation ("Zenith"), a supplier of materials used by automotive equipment manufacturers, filed a voluntary petition for relief under chapter 11 of the Bankruptcy Code.

Two days after the commencement of Zenith's chapter 11 case, the bankruptcy court entered an order authorizing, but not requiring Zenith, in its discretion and using its business judgment, to make payments of prepetition claims up to an aggregate amount of $1,000,000 to certain unidentified essential vendors of goods and services to Zenith.

On March 10, 2004, Zenith commenced an action against Longwood Elastomers, Inc. ("Longwood"), a supplier of goods used in the production of Zenith's products, seeking to avoid, as preferential payments pursuant to section 547 of the Bankruptcy Code, prepetition payments made by Zenith to Longwood in the amount $1,317,587. Longwood asserted a number of defenses, including that a payment of $506,035 made by Zenith to Longwood on the eve of Zenith's chapter 11 case was not a preferential payment because Longwood was a critical vendor and such payment was protected by the bankruptcy court's order authorizing critical vendor payments. Zenith moved to strike this defense (a procedure used to object to a legally insufficient defense).

The Bankruptcy Court's Decision

Faced with Longwood's "critical vendor" defense the bankruptcy court considered the effect of the critical vendor payment order on prepetition payments made to an allegedly critical vendor. Longwood argued that if it had not received the allegedly preferential prepetition payment, it would have been a critical vendor and the prepetition payment would have been made to Longwood postpetition under the auspices of the critical vendor payment order. Under Longwood's theory, Longwood would not receive more than it would receive in a hypothetical chapter 7 case of Zenith, and, therefore, the prepetition payment did not meet all of the criteria for a preferential payment.

Longwood cited two primary cases to support its argument. In the first case, Kimmelman v. Port Authority of New York & New Jersey (In re Kiwi International Air Lines, Inc.), prepetition payments to landlords of a debtor were held not to be preferential transfers because the debtor assigned the leases as part of an asset sale, thus triggering a requirement under section 365 of the Bankruptcy Code that the debtor pay all amounts due under the leases upon assignment. Accordingly, the court held that payments were "not recoverable as preferences because, had the creditors not received the payments pre-petition, they would have received amounts reflecting those sums, in any event, when the Bankruptcy Court approved the cures of the assumed agreements." In the second case, Official Committee of Unsecured Creditors v. Medical Mutual of Ohio (In re Primary Health Systems, Inc.), payments to an administrator of the debtor's employee benefits plan were held not to be preferential transfers because the court had entered an order generally approving the payment of prepetition claims for wages and benefits. In this instance, the payments could not be avoided as preferences because they were made pursuant to and after entry of an order of the court.

The bankruptcy court in Zenith, however, distinguished both the Kiwi and Primary Health Systems cases from the facts in Longwood. First, the bankruptcy court noted that Kiwi was inapposite because payments to Zenith's critical vendors were discretionary, whereas the cure payments made by the debtor in Kiwi to its landlords were mandatory upon assignment of their leases. Moreover, the court noted that the critical vendor order at issue in Longwood did not identify the beneficiaries of the order and Longwood could not be a beneficiary of the order since it had been paid prepetition.

The bankruptcy court also distinguished Primary Health Systems and concluded it "to be inapplicable to whether a preference action is barred by the entry of a critical vendor order that may implicate the preference action defendant." Moreover, the court noted how the bankruptcy judge from the Primary Health Systems case subsequently acknowledged that the entry of a critical vendor order does not foreclose preference liability. Unlike the order in Primary Health Systems which authorized payment of a claim that would have been afforded priority under section 507 of the Bankruptcy Code if it had not been paid pursuant to such order, Longwood's prepetition payment would only have resulted in a general unsecured claim if it had not been paid. Accordingly, the recipient of the prepetition payment in Primary Health Systems, as a priority claimant, would have been paid ahead of general unsecured creditors in a chapter 7 liquidation of the debtor and did not involve a situation where one unsecured creditor was being preferred over another.

The bankruptcy court next noted that approval of a critical vendor payment motion is discretionary and based on the specific facts of each case. The court concluded that even if Longwood could prove that Zenith considered Longwood's goods and services critical to its survival, and that Zenith intended to pay Longwood under the critical vendor order absent the $506,035 prepetition payment, Longwood could not prove that the bankruptcy court would have approved the critical vendor motion. The bankruptcy court found it speculative that no party in interest would object, including the debtor's secured lender or the United States Trustee, to a motion based on very different facts from the one approved by the court. If the payment to Longwood was added to the critical vendor motion, it would have resulted in a 50% increase to the maximum amount of payments authorized by the critical vendor payment order. The court concluded that the United States Trustee, Zenith's prepetition secured lenders or the bankruptcy court itself might have objected to a critical vendor order seeking authorization to make payments of up to approximately $1.5 million, especially with a payment of $506,035 to one creditor.

Ultimately, the bankruptcy court granted Zenith's motion to strike Longwood's critical vendor defense because the court found the defense legally insufficient to prevent recovery of the preference.

Conclusion

The decision in Zenith stands for the proposition that at least in the District of Delaware, a creditor who received a prepetition payment immediately prior to a debtor's commencement of a chapter 11 case, who might otherwise have been paid postpetition pursuant to a critical vendor order, may be required pursuant to a preference action to turn over to the debtor's estate the payment it received prepetition. Whether the critical vendor defense remains a viable defense in other jurisdictions remains to be seen.

Zenith Indus. Corp. v. Longwood Elastomers, Inc. (In re Zenith Indus. Corp.), 319 B.R. 810 (Bankr. D. Del. 2005).

Kimmelman v. Port Auth. of N.Y. & N.J. (In re Kiwi Int'l Air Lines, Inc.), 344 F.3d 311 (3d Cir. 2003).

Official Comm. of Unsecured Creditors v. Med. Mut. of Ohio (In re Primary Health Sys., Inc.), 275 B.R. 709 (Bankr. D. Del. 2002).