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National Association of Credit Management
THE PUBLICATION FOR
CREDIT AND FINANCE PROFESSIONALS
September 2003
Trade Creditors Beware: Providing Post-Petition
Goods and Services to a Chapter 11 Debtor Under a
Pre-Petition Contract Without Protection Can Be
Toxic to Collectibility
By Bruce S. Nathan, Esq.
Introduction
Well, the Kmart case has generated
court decisions on lots of interesting
issues: critical vendor, landlord
rights—you name it! And now in the
spirit of the focus on software issues
this month, the bankruptcy court in
Kmart addressed a software provider’s
administrative claim for post-petition
services under a rejected pre-petition
contract. Prior to Kmart’s Chapter 11,
one of Kmart’s software providers, JDA
Software, Inc. had entered into various
agreements with Kmart to modify certain Kmart software programs. JDA
installed modified software and performed services for Kmart before and
after Kmart’s Chapter 11 filing.
JDA invoiced Kmart for its post-petition
charges, anticipating full payment of its
claim as an administrative priority claim.
Boy was JDA in for a rude awakening!
Kmart disputed JDA’s administrative
claim because Kmart had rejected its
pre-petition agreements with JDA during
the Chapter 11 and did not use or benefit from the software modifications and
services that JDA had provided.
Kmart and denied JDA’s administrative
claim for its unpaid post-petition invoices. JDA was not entitled to an administrative expense claim just because JDA
had performed software modification
work post-petition for Kmart. JDA also
had to prove that its work benefited
Kmart, which JDA could not do. The
court found that Kmart had not benefited from JDA’s post-petition work
because Kmart rejected its agreements
with JDA during the Chapter 11 and
never used the software modifications
provided by JDA.
with a modified version of Kmart’s
inventory and pricing software for use
in a store that Kmart had planned to
open in Trinidad and for later use in an
unspecified number of stores that
Kmart had planned to open in the
Caribbean. The modified software was
supposed to integrate Kmart’s
Caribbean stores with the main Kmart
computer system, enabling Kmart to
track sales and inventory and update
pricing of various products while taking into account the differences in currency, language and taxation.
Of course, that meant a huge loss for
JDA. The court refused to grant JDA a
fully payable administrative claim for its
post-petition invoices. JDA was left with
a pre-petition unsecured damage claim
from Kmart’s rejection of its agreements
with JDA and the software modifications. That will yield JDA a small distribution under Kmart’s recently approved
Chapter 11 plan.
JDA and Kmart entered into (1) a software license agreement for various software programs; (2) a services agreement
in connection with certain of the
licensed software; and (3) a software
support agreement under which JDA
had agreed to provide software services
starting on March 1, 2002.
Could JDA have avoided its plight? Read
on and you will see.
Background
The United States Bankruptcy Court for
the Northern District of Illinois, in In re
Kmart Corporation, held in favor of
On January 22, 2002, Kmart and 37 of
its affiliates had filed Chapter 11. JDA
previously agreed to provide Kmart
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1
JDA began work under the JDA agreements and installed software on
Kmart’s computer system prior to
Kmart’s Chapter 11 filing. JDA continued work during Kmart’s Chapter 11
case. A Kmart representative had
informed JDA during the case that
Kmart’s Caribbean project was “still a
go” and JDA should continue working
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post-petition. Kmart personnel also
promised that JDA’s post-petition work
would be compensated as an administrative priority expense claim under
Section 503(b) of the Bankruptcy
Code as an inducement for JDA to continue post-petition work under the
JDA Agreements. JDA continued work
for Kmart post-petition in reliance on
Kmart’s representations and promises.
But on February 5, 2002, Kmart representatives told JDA that Kmart was
delaying the opening of a Caribbean
store and JDA’s services were no
longer necessary. As of February 5,
2002, JDA had completed and was
ready to deliver some, but not all, of
the necessary modifications to one of
Kmart’s software programs. Kmart
refused to accept delivery of these
modifications and in late February
2002, Kmart deleted from its computer
system all of the previously installed
modified JDA software related to the
Caribbean project.
In February 2002 JDA billed $240,400.56
for post-petition services under the
services agreement. JDA also claimed
$50,342.47 for post-petition support
services provided to Kmart under
the support agreement between
March 1, 2002 and May 9, 2002.
On May 9, 2002, Kmart filed a motion
to reject its agreements with JDA pursuant to Section 365 of the Bankruptcy
Code. On May 7, 2002, the court
entered an agreed order approving
Kmart’s rejection of the JDA agreements as of May 9, 2002. Kmart also
postponed the Caribbean program at
about the same time.
JDA requested bankruptcy court
approval of the allowance and payment of an administrative expense
claim in the amount of $290,743.03
for its post-petition services under the
JDA agreements, pursuant to Section
503(b) and 507(a) of the Bankruptcy
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Code. The court denied this request,
leaving JDA pretty much high and dry!
Administrative Priority Claims
In bankruptcy, claims are paid based
on where they are situated on the
claims priority ladder.At the top of the
ladder are secured creditors who are
entitled to payment from the proceeds of their collateral. Next in line
are the administrative priority claims
of creditors that provide goods and
services on credit terms to the debtor
or trustee or to whom the debtor or
trustee becomes indebted during the
bankruptcy case. As a general rule,
administrative claims must be paid in
full before any payment can be made
to holders of lower priority claims.
Next in line are the lower-level priority claims, such as certain employee
wage, salary, benefit, tax and other
claims. Pre-petition unsecured creditors occupy the lowest creditor rung
of the priority ladder and are not entitled to any distribution until the higher priority creditors are paid in full.
According to Section 503(b) of the
Bankruptcy Code, an administrative
priority claim is an actual and necessary cost and expense of preserving
the debtor’s bankruptcy estate. For
instance, a trade creditor that sold and
delivered goods or provided services,
post-petition, on credit terms, to a
Chapter 11 debtor is entitled to an
administrative priority claim against
the debtor for any unpaid claim, with a
prior right to payment of its claim
ahead of the claims of the debtor’s
pre-petition unsecured creditors.
The Bankruptcy Code affords priority
status to induce creditors to extend
credit to and do business with a
debtor or trustee during the bankruptcy case. This is designed to increase
the likelihood that the debtor will successfully rehabilitate its business and
emerge from its Chapter 11 as a going
concern. In the absence of such pro-
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2
tection, creditors and other third parties may refuse to extend credit to the
debtor out of concern that their claims
would not be paid.
Denial of JDA’s Administrative
Claim for Post-Petition
Invoices
The court refused to grant JDA an
administrative priority claim and payment of its post-petition invoices due
from Kmart. The court stated that a
claim is entitled to administrative priority status if it (1) arises out of a transaction with the debtor in possession
and (2) is beneficial to the operation
of the debtor’s business. A claimant
seeking an administrative priority
claim must demonstrate that its transaction with the debtor realized an
actual, concrete benefit for the
debtor’s estate; a speculative or potential benefit will not do. The court
imposed a tough burden for proving
entitlement to an administrative priority claim because the debtor usually
has limited resources to equally distribute among creditors.
There was no dispute that JDA’s claim
arose out of its transactions with Kmart
as a debtor in possession, thus satisfying
the first requirement for an administrative claim. The second requirement,
specifically whether the work JDA
performed post-petition for Kmart had
benefited Kmart’s estate, was at issue in
the case.
Kmart argued that a debtor benefits
from a creditor’s post-petition goods
and/or services only when the debtor
actually uses them. JDA could not
demonstrate that Kmart actually utilized
JDA’s software modifications or other
services during the Chapter 11. As
a result, JDA was not entitled to payment of its post-petition invoices as an
administrative claim.
JDA countered that JDA’s services
benefited Kmart and its bankruptcy
BUSINESS C REDIT
estate because, during its bankruptcy
case, Kmart had requested that JDA
continue work under the JDA
agreements.As a result, JDA was entitled
to payment of its post-petition invoices
as an administrative expense claim.
The court sided with Kmart and denied
JDA an administrative priority claim for its
post-petition invoices. JDA’s post-petition
performance of its agreements with
Kmart did not automatically translate into
a benefit to Kmart’s estate, even if Kmart
had induced JDA’s performance.
Kmart had nothing to show for, and
received no benefit from, the post-petition work that JDA had performed.
JDA’s software modifications were of
no value to Kmart, as demonstrated by
Kmart’s deletion of JDA’s software
from Kmart’s computer system in
February 2002.
The fact that JDA had performed work
on software modifications for Kmart
during the Chapter 11 did not in and
of itself mean that Kmart had used and
benefited from JDA’s work. JDA’s postpetition work that might in the future
realize some potential benefit
to Kmart is too speculative to be
allowed as an administrative priority
expense claim.
JDA would have been entitled to an
administrative priority claim for its
post-petition invoices only where
Kmart had utilized and thereby benefited from the software modifications
and services provided by JDA during
the Chapter 11. That simply did not
happen—even though JDA had performed work on software modifications for Kmart during the Chapter
11, JDA’s efforts did not benefit
Kmart’s estate because Kmart
did not utilize any of the
software modifications.
Conclusion
Where a debtor, such as Kmart, and a
vendor, such as JDA, entered into a prepetition contract that was not fully performed when the debtor had filed for
bankruptcy, the creditor is exposed to
significant risk if it continues to perform
under the contract during the bankruptcy. The creditor should protect itself
from the risk of the debtor’s rejection of
the contract and refusal to pay for goods
sold and/or services provided by the
creditor under the contract during the
Chapter 11 and prior to rejection.
The creditor could compel the debtor
to assume the contract or make other
arrangements to insure the debtor’s
performance under the contract during the bankruptcy.Absent this protection, a creditor that continues to
perform under a pre-petition contract
and incurs expense during the bankruptcy might find itself out in the cold
in the event the debtor later rejects or
cancels the contract during the bankruptcy case, and opposes the creditor’s
administrative priority claim for its
unpaid invoices for goods and/or services provided during the bankruptcy
based on a lack of benefit to the
debtor and its bankruptcy estate. The
creditor is then left with a
low-priority pre-petition general unsecured claim for its damages from the
debtor’s rejection or cancellation of
the contract.
The creditor could also protect itself
by demanding a deposit or third-party
support to secure the debtor’s obligation to perform under its pre-petition
contract. For example, JDA could have
insisted that Kmart post a deposit
with JDA or arrange for the issuance
of a letter of credit in favor of JDA or
a guarantee of payment from a creditworthy third party. Since JDA did not
negotiate for such protection, its only
recourse was a pre-petition general
unsecured claim for its damages from
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3
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Kmart’s rejection of the JDA agreement. JDA was left “crying the blues”
with the prospect of a de minimus
recovery, in contrast to the full recovery it would have obtained in
the event it had been granted an
allowed administrative claim for its
post-petition invoices.
Bruce S. Nathan, Esq. is a partner in
the law firm of Lowenstein Sandler
PC in New York, NY. He is also a
member of NACM and the
American Bankruptcy Institute. He
can be reached via e-mail at
[email protected].