The Examiners: Eliminate Vendor Priority Claims

If you could make one change to the bankruptcy code, what would it be?

As tempted as I am to decry the enormous regulatory subsidy for the financial services industry in the form of the financial contracts safe harbors from the automatic stay and avoidance actions, these safe harbors have not undermined the effectiveness of bankruptcy. The financial contract safe harbors are a problem because of their effects outside of bankruptcy. If we want to make the bankruptcy process itself work better, the single best change to the bankruptcy code would be to repeal section 503(b)(9), which gives administrative priority status to the claims of vendors for the value of goods sold to the debtor in the ordinary course of the debtor’s business within 20 days before the bankruptcy filing.

Chapter 11 plans are required to pay all administrative priority claims in full and in cash on the effective date of the plan. The more administrative priority claims a debtor has, the more cash the debtor needs to have on hand to confirm a plan. Circuit City, for example, had around $350 million of these types of claims, which was one of the factors inhibiting its restructuring. Because of these claims, Chapter 11 does not work for many retailers.

Section 503(b)(9) was added (along with many other misguided “reforms”) as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. The provision was intended to facilitate the extension of trade credit to distressed firms. It is not clear, however, that it does. To the extent it prioritizes certain claims for the sale of goods, it de-prioritizes claims for the sale of services, so the lower pre-bankruptcy cost of goods might be offset by a higher cost of services. The provision was also intended to protect vendors, but because in fact it makes it impossible for most retailers to reorganize, it may actually hurt many vendors in the end by costing them a customer while not actually guaranteeing repayment.

Section 503(b)(9) makes many trade claims functionally “secured” in that they expect repayment in full. Reorganization is extremely difficult in a world of all “generals” and no “privates.” That is because to reorganize, some creditors will have to make concessions, but provisions like section 503(b)(9) prevent concessions from being forced on creditors in the Chapter 11 process. Outside of bankruptcy, a debtor cannot force restructuring terms on creditors who don’t consent. Bankruptcy provides debtors with the legal authority to force holdout creditors into a deal; everything is done in the shadow of cramdown. Provisions like section 503(b)(9) restore holdout rights and thus undermine the bankruptcy process. If we want Chapter 11 to continue to work for retail firms, section 503(b)(9) needs to be repealed.

Adam J. Levitin is a professor of law at Georgetown University Law Center in Washington, D.C. Follow him on Twitter at @AdamLevitin