The first day motion of Arclin US Holdings Inc. and its 6 co-debtor affiliates (“Arclin”) to pay “critical vendors” illustrates how dramatically the “critical vendor” concept can vary from industry to industry. The motion also illustrates how a “critical vendor” motion can be used by a debtor to extract post petition concessions from suppliers holding administrative expense claims under Section 503(b)(9). Finally, the case presents an interesting situation where a debtor argues in favor of inclusion of freight costs in 503(b)(9) claims.
Arclin is a key manufacturer in the building and construction industry. Arclin and its non-debtor Canadian affiliates (the “CCAA Debtors” and with Arclin, the “Arclin Group” develops, produces, and markets bonding and surfacing products and technology for the engineered materials markets. The resin bonding products are used predominantly in the manufacture of residential and industrial construction materials such as particleboard, medium density fiberboard, plywood. Arclin Group is a major manufacturer in the building and construction industries holding about 25 percent of the resins market in the United States and Canada.
The Critical Shippers Subset of Arclin’s Critical Vendors
In its bankruptcy, Arclin has given special attention to its shippers, including dedicated carriers, common carriers, rail carries, and truckers. Arclin has created a subset of “Critical Vendors” that Arclin calls “Critical Shippers”. In other industries, companies providing transportation services are seldom seen as “critical vendors”. If they receive special treatment at all, that treatment comes in a motion to pay potential lien claimants.
For Arclin shipping forms a critical link its operations both as regards to raw materials purchased and goods sold. Arclin identified 5 elements of its reliance of shippers that put certain of them in a “Critical Vendor” category:
- The Critical Shippers operate along established and carefully scheduled routes, providing the Debtors with an integrated mechanism for receiving incoming raw materials and delivering outgoing finished products.
- The Critical Shippers must utilize dedicated, specialized tanker trucks and rail cars to deliver the Debtors’ raw materials. Those tankers and rail cars cannot be used for other materials without being specially cleaned at the Debtors’ expense.
- The Critical Shippers that operate rail lines have exclusive control over the railroad tracks that run adjacent to the Debtors’ facilities. Thus, those Critical Shippers cannot be readily replaced with a convenient or cost-effective alternative.
- The Critical Shippers may have state law liens with respect to goods in transit as of the Petition Date.
- Replacing the Critical Shippers would take at least three months, during which time the Debtors’ operations would be effectively shut down.
Based upon these 5 criteria, Arclin seeks to pay up to $900,000 to “Critical Shippers” in payment of pre-petition claims.
Arclin Seeks Approval to Pay $9.3 Million to Other Critical Vendors
Arclin also seeks to pay $9.3 million to suppliers fitting into a more traditional category of “Critical Vendors” – raw material suppliers. Arclin uses four primary raw materials in its resins business: urea, methanol, phenol and melamine. Arclin argued that these raw material suppliers should be considered “Critical Vendors” for 4 reasons:
- The Debtors generally operate their business with minimal inventory levels for their Raw Materials, in most cases with less than one week of inventory on hand. Any impediment to the Debtors’ ability to source Raw Materials on a competitive basis may result in higher Raw Material costs, which would impact the Debtors’ profit margins.
- The Debtors’ Raw Materials arrive via railway from all over North America, resulting in lead times for new Raw Materials of up to 40 days. If the Debtors Raw Materials suppliers suspend delivery to the Debtors, one or more of Debtors’ plants may be required to shutdown.
- Because the Debtors supply their customers on a just-in-time basis, if one of the Debtors; plants is required to shutdown, a customer plant also may be forced to shutdown. Should this occur, the relationship with the customer would be damaged permanently and the customer would likely take its business to a competitor of the Debtors.
- Critical Suppliers willing to continue providing Raw Materials to the Debtors will likely require the Debtors to accept less favorable terms than those previously made available to the Debtors. By paying the prepetition claims of the Critical Suppliers, the Debtors will be able to maintain the same or more favorable terms for the Raw Materials.
Compared to other industries, these criteria for “critical vendor” classification would be considered weak. The focus on the potential for increase in cost if another raw material supplier is used is not even mentioned as a criterion in other industries. Instead, the focus is on quality assurance and testing requirements if a supplier is changed.
503(b)(9) Administrative Expense Claims Muddled with Critical Vendor Claims
Approximately $7.7 million of the Critical Supplier Claims relates to goods received by the Debtors within 20 days of the Petition Date. Claims for payment of these is entitled to administrative expense status under Bankruptcy Code section 503(b)(9) (the “503(b)(9) Claims”). All administrative expense claims must be paid as a condition to the confirmation of a plan of reorganization.
Arclin muddles the distinction between 503(b)(9) Claims and Critical Vendor Claims. This muddling likely is intentional. We can think of 2 reasons why a debtor might want to mix together these totally distinct types of claims.
First, Arclin has a genuine concern for justifying different treatment of claims within the same class. Arclin is expecting to file a plan of reorganization pursuant to which existing secured lenders will convert much of their debt to equity. Under this anticipated plan there is no mention of making any payment to holders of general unsecured claims. By stressing that most of the Critical Vendor Claims would be paid in any event as administrate expense claims, Arclin may be trying to head off objections to payment of pre-petition, unsecured Critical Vendor Claims when many unsecured creditors likely will receive nothing.
A second possible reason for blurring 503(b)(9) and Critical Vendor Claims is a strategic one in negotiating post petition trade credit terms. Contraction of Arclin’s trade credit would severely impact its liquidity. Arclin needs some leverage to extract continued favorable payment terms from its suppliers.
There is a definite negotiating advantage in using Critical Vendor status to extract favorable terms. There is a big difference between a debtor being able to say to a supplier “Give us favorable terms and we will pay your prepetition claims” and saying “Give us favorable terms and we will pay your 503(b)(9) claim now versus in a few months.”
The bottom line – Arclin is going to have to pay $7.7 million of the “Critical Supplier Claims” as 503(b)(9) claims in any event. The debtor strategy may be to try and get concessions from vendors in exchange for paying what Arclin already will be required to pay as a condition to confirmation of a plan of reorganization.
Arclin Argues that Freight Costs Should be Included in 503(b)(9) Claims
Section 503(b)(9) only gives administrative expense priority for the value of “goods” received by the debtor in the 20 days prior to bankruptcy. Debtor’s counsel have traditionally argued that transportation charges are “services” and have used this argument to ding suppliers’ 503(b)(9) claims.
In an unusual non-debtor position, Arclin argues that the freight costs are properly part of 503(b)(9) claims. Arclin argues:
With respect to the cost of freight that is built into the purchase price of raw materials that the Debtors buy, the Debtors submit the related prepetition claim should be considered a 503(b)(9) Claim, to the extent the materials were received within 20 days of the Petition Date. The Debtors typically sell their products FOB (customer locations), and the cost of shipping is included in a customer’s invoice as part of the sales price.
For Arclin Suppliers its 503(b)(9) Claim, Critical Vendor Claim, Reclamation Claim … or Bust
From the supplier perspective, the Arclin bankruptcy looks like a mixed bag. For those suppliers with general unsecured claims in excess of their 503(b)(9) claims, full payment hinges on either being classed as a “Critical Vendor” or playing the reclamation claim game. For suppliers whose pre-petition claims all qualify as 503(b)(9) claims, the decision on whether to accept payment as a “Critical Vendor” will likely boil down to two factors:
- the level of certainty that a plan of reorganization is going to be confirmed and confirmed quickly; and
- the exposure arising out of the terms Arclin is seeking in exchange for critical vendor treatment.