Lear Corporation and co-debtor subsidiaries (“Lear”) have estimated that they collectively have 1,600 vendors with outstanding prepetition claims.  Lear has identified 214 of these vendors as “critical vendors”.  As part of its first day motions, Lear has requested an order from the Bankruptcy Court authorizing Lear to pay up to an aggregate of $50,100,000 ($25,050,000 pursuant to an interim order and up to an additional $25,050,000 pursuant to a final order) of prepetition claims held by these 214 “critical vendors.”   In the Lear bankruptcies and in other bankruptcies where similar motions have been filed, suppliers (and their lenders and stakeholders) repeatedly are asking:  “What is a ‘critical vendor’ and what are the chances of my company being one?”

The Criteria for Critical Vendor Identification

Lear has capped its request to pay critical vendor prepetition claims at 33.5 percent of its total prepetition trade related payables.  Lear states that, in separating the claims of critical vendors from the claims of other trade creditors, it has systematically reviewed its accounts payable and list of prepetition vendors and consulted with Lears’ management.  Lear has identified 8 criteria it applied in this process.  These identified criteria are whether:

(a)     a particular vendor is a sole source provider;
(b)     quality control or other contractual requirements of the Customers prevent the Debtors from replacing the vendor;
(c)     the vendor supplies the Debtors with highly engineered component parts that require substantial lead time to develop and produce;
(d)     the Debtors currently receive advantageous pricing or other terms from a vendor;
(e)     the vendor might face its own liquidity crisis, due to such vendor’s operational or cash flow issues, if the Debtors do not promptly pay its prepetition claim, meaning that a missed payment could cause such vendors to fail;
(f)     the vendor does not have a long-term supply contract with the Debtors;
(g)    the vendor does have a long-term supply contract with the Debtors, pursuant to which the Debtors could compel performance from such vendor in a bankruptcy proceeding; and
(h)     enforcement of the terms of such a long-term supply contract against a recalcitrant vendor could be accomplished in a timely and cost-efficient manner without unduly disrupting the Debtors’ operations in light of all relevant circumstances.

These criteria are not unique to the Lear bankruptcy.  We have seen similar (if not identical) criteria listed in other recent automotive supplier bankruptcy critical vendor motions.  While we appreciate the effort to put some parameters around the determination, we believe that the practical determination of who is and is not a critical vendor boils down to one word:  “leverage”.

A Practical Approach to Critical Vendor Analysis

For an automotive supplier dealing with a customer’s bankruptcy, “leverage” simply is the result of (1) ability to act (or refuse to act) and (2) the impact on the customer if that ability is exercised.

The first element, ability to act, is very difficult to evaluate.  The analysis involves complex questions of law and requires consultation with bankruptcy creditor counsel.  The ramifications for a misjudgment can be hugely expensive and otherwise catastrophic.  A supplier who considers determining on its own what actions it can take in response to a customer’s bankruptcy should also consider the prudence of a self administered frontal lobe lobotomy.  That understood, the actions that an automotive supplier’s customer is likely to be most concerned about are indicated by items (e) through (h) in the Lear criteria listing.

The second element, the impact of any action that the supplier might take, typically is within the business knowledge of most suppliers.  By considering items (a) through (d) of the criteria listed by Lear, a supplier can get a pretty good idea of the inquiry the supplier might undertake.

First Supplier Worry — Whether There will be a Critical Vendor Motion

You will not find a section of the Bankruptcy Code that allows a supplier to request special treatment as a “critical vendor” or “essential supplier”.  In fact, the concept of a critical vendor is not mentioned in the Bankruptcy Code at all – it is a creation of the bankruptcy courts.  For this reason, if the bankrupt customer is not requesting a critical vendor order in its first day motions, a supplier can stop worrying about being a critical vendor.

Whether a customer is going to request an order to pay critical vendors and the scope of that order, if requested, is determined by factors usually beyond any one supplier’s ability to influence.  A few of these factors are

  • The jurisdiction where the bankruptcy was filed — the bankruptcy courts of some jurisdictions continue to be hostile to critical vendor motions.
  • The willingness of the provider of debtor in possession financing and the prepetition secured lenders to allow for critical vendor payments of pre-petition claims.
  • The debtor’s plan for the bankruptcy — for example, if the debtor anticipates a “liquidating 11” it is much less likely that it will make a critical vendor motion.
  • The debtor’s budget — if there is no money in the budget, it makes no difference how much the debtor wants to pay the supplier.
  • Whether there is going to be a 363 sale — simply, some buyers, and especially private equity buyers, do not fully appreciate the need to support the supply base.

The Price of Critical Vendor Treatment – A Bargain with the Devil

Treatment as a critical vendor almost always is at the cost of agreeing to favorable terms for post petition supply of goods and services.  These terms might even be better than the terms the supplier offered immediately prior to bankruptcy.  These terms are usually embodied in a “Trade Agreement” the supplier is required to sign to get the critical vendor payment.  We have seen some absolutely horrible terms in these trade agreements, but that is the subject for another post.

As to the simple issue of payment terms, Lear provides a good example of why a critical vendor motion can make a lot of sense.  Lear is requiring that suppliers receiving critical vendor status agree to return to the most favorable terms that the supplier offered in the 180 days prior to bankruptcy.  The reason for this demand is that Lear experienced a drastic reduction in trade credit in the months before it filed bankruptcy.  As Lear explained:

In the months immediately preceding the Petition Date, approximately 148 of the Debtors’ suppliers—with which the Debtors collectively have nearly $1 billion in yearly purchases—attempted to contract the trade terms under which they provide goods and services to the Debtors. Of these, 31 have requested reductions in trade terms from approximately 50 days after delivery of product to cash-in-advance of delivery.  More than 74 other suppliers have requested that the Debtors make cash payments immediately upon delivery of product.  Still other suppliers have requested some form of adequate assurance from the Debtors, posting of a bond or letter of credit, assistance with obtaining credit insurance, and various other forms of assurance.

Lear estimated that the annual negative impact to working capital due to changes to trade terms year-to-date exceeded $38 million.  So if paying $50 million now helps get $38 million back in trade credit plus the ongoing benefit of the supply base absorption of carrying costs, the critical vendor motion looks like a good deal for Lear.