On Feb. 24, 2004, the U.S. Court of Appeals for the Seventh Circuit affirmed a U.S. District Court's reversal of a bankruptcy court order that had granted Kmart authority to pay the pre-petition clams of vendors that Kmart deemed critical to its continued business, provided that any such "critical vendor" agreed to continue furnishing goods on "customary trade terms" for two years.¹ The Seventh Circuit's decision, and the district court's prior decision, have generated more commentary and discussion about first-day motions than any other decision in recent history. Much of this commentary has suggested that the critical-vendor doctrine has essentially been abolished in the Seventh Circuit and elsewhere. In fact, these reports are exaggerated and without substantive merit. The Kmart decision does not flatly reject the critical-vendor doctrine; it merely limits the situations in which such orders will be deemed appropriate in the Seventh Circuit. The Kmart decision suggests that bankruptcy courts may issue critical-vendor orders, in limited situations, pursuant to §363(b)(1) of the Bankruptcy Code.² Thus, in preparing for a chapter 11 filing in a complex bankruptcy case, practitioners should carefully consider the implications of Kmart in terms of venue selection and drafting first-day motions.

The Kmart decision casts a cloud over a doctrine that was already mired with uncertainty. Courts have established widely divergent standards with respect to the critical-vendor doctrine. For those of you keeping score, the current status of the critical-vendor doctrine in the appeals courts is as follows: (1) The Seventh Circuit has limited the critical-vendor doctrine; (2) the Ninth, Fifth and Fourth Circuits have rejected the doctrine; and (3) the Third Circuit has consistently recognized the doctrine.³ Therefore, this may be a factor for debtors choosing among alternative venues in which to file their respective bankruptcy petitions.

In light of the Kmart decision, debtors seeking authority in the Seventh Circuit to pay critical vendors for pre-petition goods or services should seek an order pursuant to §363(b)(1) of the Bankruptcy Code, and must establish an evidentiary basis supporting their assertion that (1) such payments are, in fact, "critical" to their reorganization, (2) discrimination among unsecured creditors is the only way to facilitate a reorganization, (3) non-critical vendors will be at least as well off as they would otherwise be if the critical-vendor order is not entered, and (4) such payments will not diminish the amount of funds that ultimately will be available for payment to non-critical vendors. Debtors may not simply request broad authority to pay all "critical vendors" in the Seventh Circuit, and instead will need to specify which pre-petition vendors are indeed critical. Moreover, given the Seventh Circuit concerns about notice of a critical-vendor motion to non-critical vendors, debtors should also consider providing broader notice of such motion so that non-critical vendors have a better opportunity to respond to such motions.⁴

The Critical-vendor Doctrine

The "critical-vendor doctrine"⁵ has been utilized by chapter 11 debtors to pay pre-petition debts owed to vendors that the debtors deem to be "critical" to their respective reorganization efforts. The doctrine is based on the theory that such vendors would refuse to engage in post-petition business with the debtor unless, and until, their pre-petition obligations are paid in full. Because these vendors are integral to the debtor's ongoing business operation, their refusal to engage in prospective business would cripple the debtor's ability to carry on, thus frustrating the debtor's reorganization efforts and injuring all of the debtors' creditors.

Kmart's Critical-vendor Saga

Kmart Corp. plus 37 of its affiliates and subsidiaries filed chapter 11 petitions on Jan. 22, 2002, in the U.S. Bankruptcy Court for the Northern District of Illinois. As part of its first-day motions, Kmart filed a motion seeking authority to pay pre-petition obligations to its critical vendors. According to Kmart, such payments were necessary to maintain business relationships with the respective vendors, and the vendors' goods were essential to Kmart's continued operations (and hence, its successful reorganization). Capitol Factor, a factoring agent for a number of the debtors' apparel suppliers that held $20 million in claims against the debtor, was not included among the vendors to be paid pursuant to the critical-vendor motion, and objected to the motion.

The bankruptcy court found that the payment of the requested pre-petition obligations to critical vendors was necessary to maintain Kmart's business as a going concern and, therefore, for it to reorganize successfully under chapter 11. Accordingly, the bankruptcy court granted Kmart's critical-vendor motion. Pursuant to the critical-vendor motion, the debtor paid 2,330 suppliers a total of approximately $300 million in full satisfaction of pre-petition debts. Kmart's approximately 2,000 other vendors, which were apparently not deemed "critical," were not paid or notified of the debtor's motion and the court's subsequent order.

The district court reversed the bankruptcy court's order. The district court acknowledged that the bankruptcy court's application of the "doctrine of necessity" was "well-intended and may even have some beneficial results," but the district court ultimately concluded that there was no authority under the Bankruptcy Code to afford priority status for the payment of certain pre-petition obligations to vendors. The district court determined that such payments were (1) not authorized by §105(a)'s broad grant of equitable power and (2) contrary to the Code's explicit priority scheme. Citing Seventh Circuit precedent, the court stated that §105 only permits bankruptcy courts to use their equitable powers to enforce Code provisions, and not to draft new ones. Further, the district court rejected the debtor's argument that it would have to file thousands of lawsuits to recover the amounts that had already been paid pursuant to the critical-vendor order. The district court noted that the debtor had not presented evidence to support its assertion that lawsuits would be necessary to recover the amount and, in any event, the debtor had failed to cite any authority that a court could not order the return of payments.

The Seventh Circuit affirmed the district court's ruling in the Kmart decision.⁶ The Seventh Circuit's decision does not flatly reject the critical-vendor doctrine, but it does indicate that any debtor seeking authority to pay its critical vendors must be prepared to satisfy heightened procedural and evidentiary standards. Specifically, the Kmart decision notes that the bankruptcy court issued Kmart's critical-vendor order without first finding (1) "that discrimination among unsecured creditors was the only way to facilitate reorganization" and (2) "that the disfavored creditors were at least as well off as they would have been had the critical vendors order not been entered."⁷ The Seventh Circuit also suggests that the non-critical vendors should have received advance notice of the motion. The Kmart decision states that "[Kmart] notified only 65 creditors of its impending request, and none of these was among the 2,000 vendors to be left high and dry."⁸

The Seventh Circuit noted that bankruptcy courts typically authorize critical-vendor payments pursuant to (1) their inherent equitable powers under §105(a) of the Bankruptcy Code⁹ or (2) the "doctrine of necessity," a legal doctrine formulated in pre-Bankruptcy Code cases in the late 19th Century, which assumes that bankruptcy courts have the authority to reorder priorities and pay particular creditors to facilitate a debtor's overall reorganization.¹⁰ The Seventh Circuit flatly rejected both of these justifications, acknowledging that §105(a) allows a bankruptcy court to issue any order necessary or appropriate to carry out the provisions of the Code. The court noted, however, that, "the power conferred by §105(a) is one to implement rather than override."¹¹ With respect to the doctrine of necessity, the Seventh Circuit noted that the doctrine is "just a fancy name for a power to depart from the Code."¹² The Seventh Circuit acknowledged the legitimacy of the doctrine of necessity before U.S. bankruptcy law was codified in the Code, but it concluded that the Code's explicit priority scheme was meant to preclude courts from using their equitable powers to adjust priority among interested parties.¹³

Kmart argued that the bankruptcy court was authorized to issue the critical-vendor order under §§363(b), 364(b) and 503 of the Code. Section 364(b) states that "the court, after notice and hearing, may authorize the trustee to obtain unsecured credit or to incur unsecured debt other than under subsection (a) of this section, allowable under §503(b)(1) of this title as an administrative expense." The Seventh Circuit stated that this section was inapposite to Kmart's argument because it only authorizes the debtor to obtain credit (as Kmart had already done), and it has nothing to say about how such money will be disbursed or about priorities among creditors.¹⁴ The Seventh Circuit also found that §503 was irrelevant to Kmart's argument because §503 deals with administrative expenses, and pre-petition debts "are the antithesis of administrative expenses."¹⁵

However, the Seventh Circuit suggested that critical-vendor payments may be authorized pursuant to §363(b)(1) of the Code, which governs a debtor's use of property outside of the ordinary use of business, subject to court approval. However, the Seventh Circuit declined to approve Kmart's critical-vendor order because it felt that the evidentiary record established in the bankruptcy court failed to establish a "critical" need to make such payments. In particular, the factual record established in the bankruptcy court failed to show that (1) discrimination among unsecured creditors was the only way to facilitate Kmart's reorganization and (2) disfavored creditors would be at least as well off as they would otherwise be if the critical vendor order was not entered.

The Status of Critical-vendor Payments Post-Kmart

The Kmart decision suggests that a critical-vendor motion may be granted pursuant to §363(b)(1) of the Code. This is consistent with the findings of several courts in other jurisdictions that had rendered opinions pre-Kmart authorizing payments under the doctrine of necessity pursuant to §363(b)(1). For example, in In re Ionosphere Clubs Inc., 98 B.R. 174 (Bankr. S.D.N.Y. 1989), the court determined that it had authority under §363 to authorize pre-plan payment of pre-petition claims of ongoing employees. Further, after the district court had reversed the bankruptcy court's decision in Kmart, the Northern District of Illinois entered an order in In re National Equip. Servs. that authorized critical vendor payments under §363(b)(1).¹⁶ This order was entered in spite of an objection by the U.S. Trustee in which the U.S. Trustee based his objection on the district court's ruling in Kmart.

The Kmart decision indicates that debtors seeking authority to make pre-petition critical-vendor payments in the Seventh Circuit pursuant to §363(b)(1) must satisfy certain procedural and evidentiary requirements. Technically, the Seventh Circuit's discussion concerning §363(b)(1) was dicta, and therefore not binding legal authority. However, in the wake of the Kmart decision, the U.S. Bankruptcy Court for the Northern District of Illinois has already utilized §363(b)(1) to authorize full payment of at least one debtor's pre-petition wage obligations.¹⁷ Accordingly, there is already empirical evidence that courts in the Seventh Circuit will adopt §363(b) as authority for authorizing critical payments.

Less Discretion by Debtors in Determining Which Payments Are "Critical"

The Seventh Circuit expressed concern that the bankruptcy court granted Kmart unfettered discretion to determine which vendors and what payments were critical to its successful reorganization. Specifically, the Seventh Circuit noted that the bankruptcy court's order granted Kmart "open-ended permission to pay any debt to any vendor it deemed 'critical' in the exercise of its unilateral discretion..."¹⁸ Therefore, any debtor seeking authority to pay its critical vendors should make sure that its critical-vendor motion includes a listing of the vendors that it deems "critical." Most debtors will likely be reluctant to disclose which of their vendors are "critical." Accordingly, a debtor that is considering filing a critical-vendor motion should consider filing a motion requesting authority to submit the critical-vendor motion (or the exhibit listing the "critical vendors") under seal. Such a filing would allow the debtor to (1) satisfy the Seventh Circuit's procedural requirements and (2) protect its confidential information. As a practical matter, this requirement may make it very difficult for debtors to make critical-vendor payments. A debtor that is trying to stop a critical vendor from ceasing its supplies may not be able to wait for the bankruptcy court to enter an order finding that the particular vendor is "critical."

Higher Burden of Proof on Debtors Seeking Authority to Pay "Critical Vendors"

The Seventh Circuit noted that the order authorizing Kmart to make critical vendor payments stated that it was "in the best interests of the debtors, their estates and their creditors," but it failed to "explain why, nor did it contain any legal analysis." Therefore, debtors seeking authority to pay their critical vendors should ensure that their motion includes the requisite evidentiary showing of why the "critical vendors" are, in fact, vital to their reorganization efforts.

The Seventh Circuit suggested that most vendors (even if their wares and/or services are necessary for reorganization) will not be "critical" to a debtor's reorganization efforts. In particular, the Kmart decision notes that the automatic stay prohibits vendors with long-term contracts from walking away—so long as the debtors pay for new deliveries. Accordingly, debtors do not require further assurance of delivery from such vendors. The Kmart decision assumes that all firms are rational, profit-maximizing entities that will disregard past experiences to gain prospective business. Accordingly, so long as the debtor pays other vendors when they deliver their respective wares, these vendors should be motivated by the profits from those sales. The Kmart decision assumes that all suppliers are rational market participants that will continue to supply a debtor so long as they receive payment for post-petition wares. In particular, the Kmart decision states, "To abjure new profits because of old debts would be to commit the sunk-cost fallacy; well-managed businesses are unlikely to do this." However, as a practical matter, debtors often find it difficult to ensure that vendors continue to provide supplies post-bankruptcy. Debtors filing critical-vendor motions should be prepared to show that each critical vendor has, in fact, threatened to stop supplying goods unless paid its pre-petition obligations.

Greater Notice Requirement for Motions Seeking Permission to Make Critical-vendor Payments

The Seventh Circuit was concerned that the non-critical vendors (or the "disfavored creditors," as the Seventh Circuit calls them) did not receive advance notice of Kmart's critical-vendor motion. Therefore, debtors seeking critical vendor orders should consider providing their non-critical vendors with notice of their critical vendor motions.

Policy Implications of the Kmart Decision

The Kmart decision is not the only source of ambiguous and/or conflicting guidance with respect to the critical-vendor doctrine. The doctrine has a long history, and there is currently a circuit split concerning the doctrine. The U.S. Supreme Court first articulated the doctrine of necessity in 1882 in the context of a railroad bankruptcy. The court stated that "[m]any circumstances may exist which may make it necessary and indispensable to the business of the road and the preservation of the property, for the receiver to pay pre-existing debts...."¹⁹ As the Seventh Circuit noted in the Kmart decision, this decision was issued before the Bankruptcy Code was enacted, and the doctrine has not been codified in the Code. Further, there is an inherent tension between the Code's explicit system of priorities and the doctrine.

The Fourth, Fifth and Ninth Circuit Courts of Appeal have each rejected the doctrine. Prior to the Kmart decision, dicta from Seventh Circuit decisions indicated an unwillingness to adopt the doctrine. In In re Chicago, Milwaukee, St. Paul & Pac. R.R. Co., 791 F.2d 524, 528 (7th Cir. 1986), the Seventh Circuit stated (with respect to the necessity-of-payment doctrine) that "the fact that a (bankruptcy) proceeding is equitable does not give the judge free-floating discretion to redistribute rights in accordance with his personal views of justice and fairness, however enlightened those may be."

The Third Circuit has recognized bankruptcy courts' authority to render critical-vendor decisions pursuant to §105(a) of the Bankruptcy Code when such payments are necessary to ensure the continued operation of the debtor's business. In In re Penn Central Transp. Co., 467 F.2d 100, 102 n.1 (3d. Cir. 1972), the Third Circuit stated, "the necessity-of-payment doctrine permits "immediate payment of claims of creditors where those creditors will not supply services or material essential to the conduct of the business until their pre-reorganization claims have been paid."²⁰ Further, in In re Lehigh & New England Railway Co., 657 F.2d 570 (3d. Cir. 1981), the Third Circuit held that a court may authorize the payment of pre-petition claims if such payment is essential to the continued operation of the debtor.²¹ Specifically, the court stated that such payments should be authorized when there "is the possibility that the creditor will employ an immediate economic sanction, failing such payment."²²

Relying on the controlling authority espoused in Penn Central and Lehigh, the U.S. District Court for the District of Delaware has also recognized the doctrine. In In re Just for Feet Inc., 242 B.R. 821 (D. Del. 1999), a chapter 11 debtor that operated retail stores specializing in athletic footwear and apparel filed a motion for authorization to pay trade vendors' pre-petition claims in exchange for customary credit terms. The U.S. Trustee, noteholders and others objected. The court authorized the debtors to pay the pre-petition claims of athletic footwear and apparel vendors as they became due in exchange for the vendors' written agreement to extend credit to the debtors on similar or better terms than the debtors enjoyed in the past. The court found that §105(a) granted it the power to authorize payment of pre-petition claims when such payments are necessary for a debtor's survival during chapter 11. The judge determined that the payment of the athletic footwear and apparel vendors' pre-petition claims was critical to the debtors' reorganization, so that said vendors would continue to provide inventory.

Bankruptcy courts in other appellate circuits have also recognized the critical-vendor doctrine. For example, in In re NVR L.P., 147 B.R. 126, 127 (Bankr. E.D. Va. 1992), the court held that, "under 11 U.S.C. §105 the court can permit pre-plan payment of a pre-petition obligation when essential to the continued operation of the debtor." In upholding the doctrine of necessity, the court in In re Eagle Pitcher Indust. Inc., 124 B.R. 1021 1023 (Bankr. S.D. Ohio 1991), stated that "to justify payment of a pre-petition unsecured creditor, debtors must show that the payment is necessary to avert a serious threat to the chapter 11 process."

Summary

The Seventh Circuit's decision in Kmart did not "kill" the critical-vendor doctrine in the Seventh Circuit or elsewhere. However, the Seventh Circuit (1) severely limited the statutory and equitable authority upon which courts in the Seventh Circuit may issue critical-vendor orders, and (2) established evidentiary and procedural requirements that a debtor must satisfy. Given the pre-existing disagreement among circuits, this decision merely adds a new metaphorical "wrinkle" to a "crumpled" doctrine. In the wake of the Kmart decision, practitioners should (1) take care to manage their client's expectations, (2) establish a specific factual record that establishes the need to pay critical vendors and lack of harm to non-critical vendors, (3) seek authority to make specific pre-petition payments in lieu of unfettered discretion and (4) consider providing notice to non-critical vendors.

Footnotes

¹ See In re Kmart Corp., 359 F.3d 866 (7th Cir. 2004). Return to article

² Section 363(b)(1) of the Bankruptcy Code provides, "[t]he trustee, after notice and hearing, may use, sell or lease, other than in the ordinary course of business, property of the estate." 11 U.S.C. §363(b)(1). Return to article

³ See Official Comm. of Equity Sec. Holders v. Mabey, 832 F.2d 299 (4th Cir. 1987); In re B&W Enters. Inc., 713 F.2d 534 (9th Cir. 1983), In re Oxford Management Inc., 4 F.3d 1329 (5th Cir. 1993); In re Penn Central Transp. Co., 467 F.2d 100 (3d. Cir. 1972). Return to article

⁴ Given the persuasive effects of the Kmart decision, debtors in other circuits should also consider following these guidelines. Return to article

⁵ The critical-vendor doctrine is part of the broader "doctrine of necessity," which has been used to pay other critical constituencies for their pre-petition obligations so that the respective parties will continue to perform post-bankruptcy. See, e.g., In re Ionosphere Clubs Inc., 98 B.R. 174, 175 (Bankr. S.D.N.Y. 1989) (holding that court had ample authority under §§363 and 105 of the Bankruptcy Code to authorize pre-plan payment of pre-petition claims of ongoing employees); In re Chateaugay Corp., 80 B.R. 279 (S.D.N.Y.) (upholding bankruptcy court's authority under §105 of the Bankruptcy Code to authorize the pre-plan payment of pre-petition employee wage and benefit claims). Return to article

⁶ See In re Kmart Corp., 359 F.3d 866 (7th Cir. 2004). Return to article

⁷ Id. at 874. Return to article

⁸ Id. at 870. Return to article

⁹ Section 105(s) states that bankruptcy courts "may issue any order, process or judgment that is necessary or appropriate to carry out the provisions of this title." 11 U.S.C. §105(a). Return to article

¹⁰ See In re Kmart Corp., 359 F.3d 866, 871 (7th Cir. 2004). Return to article

¹¹ Id. Return to article

¹² Id. Return to article

¹³ See Id. Return to article

¹⁴ See Id. at 872. Return to article

¹⁵ Id. Return to article

¹⁶ See In re National Equip. Srvcs., Order Pursuant to §§105(a), 363 and 364 of the Bankruptcy Code in Granting Debtors the Authority to Provisionally Pay in the Ordinary Course of Business Pre-petition Claims of Essential Trade Creditors, Case No. 03-27626 (Bankr. N.D. Ill. July 1, 2003). Return to article

¹⁷ See In re Jays Foods L.L.C., Final Order Under 11 U.S.C. §§363(b) and 507(a) (I) Authorizing (A) Payment of Pre-petition Employee Obligations and (B) Continuation of Employee Benefit Plans and Programs Post-petition; and (II) Directing all Banks to Honor Pre-petition Checks for Payment of Employee Obligations, Case No. 04 B 09681 (Bankr. N.D. Ill. April 4, 2004). Return to article

¹⁸ See In re Kmart Corp., 359 F.3d 866, 868 (7th Cir. 2004). Return to article

¹⁹ Miltenberger v. Logansport, 106 U.S. 286 (1882) (emphasis added). Return to article

²⁰ Id. at 102 n.1. Return to article

²¹ See Id. at 581. Return to article

²² Id. Return to article