Playing Catch Up With Pre-petition Claims Can Be Costly for Vendor

Playing Catch Up With Pre-petition Claims Can Be Costly for Vendor

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A vendor's favored account files chapter 11, leaving the vendor with a large, open account balance. The debtor requests that the vendor sell post-petition to assist in the reorganization. Selling to a debtor-in-possession (DIP) can provide certain opportunities and protections to a vendor, including an administrative claim should the debtor default on a post-petition sale. However, for an overzealous vendor who views post-petition sales as an opportunity to mark up post-petition invoices to "catch up" and reduce its pre-petition claim, with the debtor's consent, the sales may spell trouble. The bankruptcy court in In re Centennial Textiles Inc., 227 B.R. 606 (Bankr. S.D.N.Y. 1998), recently considered a vendor's liability where it allegedly submitted inflated invoices for post-petition services (priced at 68 percent above pre-petition invoices), including whether the vendor should be liable for the company's losses under a theory of conspiring to aid and abet the debtor's breach of fiduciary duties.

In Centennial Textiles, the debtor converted raw materials into finished goods in the textile industry. The vendor was a key supplier of the debtor. The debtor filed chapter 11 and the vendor had a significant pre-petition claim for services rendered. Post-petition, the vendor provided processing services to the debtor. The debtor was unable to reorganize and converted to chapter 7.

Alleged Price Increase

The chapter 7 trustee sued the vendor to recover post-petition "overpayments" by the debtor to the vendor. The trustee alleged that the debtor and the vendor entered into a fraudulent scheme to pay down the vendor's pre-petition debt. The trustee contended that the debtor agreed to pay inflated invoices submitted by the vendor for post-petition services to "catch up" and reduce its pre-petition claim. The trustee's accountant reviewed post-petition invoices, comparing the prices the debtor paid to the vendor pre-petition and post-petition for the same processing services. The trustee's accountant determined that the vendor allegedly overcharged the debtor by 68 percent on average for post-petition services.

The bankruptcy court's holding in Centennial Textiles should not deter vendors from selling to a chapter 11 debtor.

A central principle of the Bankruptcy Code is the equality of treatment of similarly situated creditors. The equality of treatment can be seen with the preference laws and plan of reorganization issues. Creditors of the same priority generally are not entitled to be paid on their pre-petition claims in chapter 11 except through a plan of reorganization, and vendors are to each be paid the same pro rata amount on their claims in both chapter 7s and chapter 11s.

The trustee in Centennial Textiles not only sued the vendor to recapture post-petition overcharges to the vendor, but also sued the vendor's vice president of finance, seeking to hold the officer liable for the bankruptcy estate's losses under a theory of a fraudulent scheme to overcharge the debtor and aiding and abetting the debtor's breach of fiduciary duties.

The bankruptcy court ordered the vendor to disgorge all post-petition overcharges, which totaled approximately $140,000. The court reviewed correspondence between the debtor and the vendor, considered testimony and determined that the debtor overpaid for post-petition services to reduce the vendor's pre-petition debt. The trustee established that the overcharges were made on account of a pre-petition debt and were unauthorized.

The court considered whether the vendor's vice president had aided and abetted a breach of fiduciary by the debtor. A chapter 11 debtor owes a fiduciary duty to creditors, which includes maximizing the value of the bankruptcy estate. The DIP, through its management, violates its fiduciary duty when it knowingly pays inflated invoices. However, the trustee failed to establish that the vendor's vice president actually knew the debtor was in bankruptcy at the time the debtor paid the inflated invoices, a necessary element to establish a breach of fiduciary claim. The court reasoned that if the vendor's vice president did not know of the bankruptcy and did not know they were fiduciaries, they could not have violated the Bankruptcy Code. Accordingly, the trustee's claims against the vendor's vice president for breach of fiduciary were dismissed.

The bankruptcy court's holding in Centennial Textiles should not deter vendors from selling to a chapter 11 debtor. A vendor's price for a product or service may fluctuate after a debtor's bankruptcy filing. However, if a vendor's post-petition prices are significantly greater than pre-petition prices, the vendor should be able to justify the price difference. The court's opinion is a reminder that a vendor's overcharges may be investigated and pursued, whether by a trustee (if one is appointed), a creditors' committee or a creditor.

Journal Date: 
Thursday, July 1, 1999