GT Alert

Seventh Circuit Casts Doubt on Common Practice of Paying Critical Vendors in Bankruptcy Cases

March 2004
By G. Ray Warner and Monica L. Loftin, Greenberg Traurig

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On the day it filed for relief under chapter 11 of the Bankruptcy Code, Kmart Corporation and its 37 affiliates sought to immediately pay, in full, the pre-petition claims of its critical vendors – i.e., those vendors whose goods or services Kmart claimed were integral to its continuing operation and reorganization. Shortly thereafter, the bankruptcy court authorized Kmart to make such payments. Kmart then fully paid the pre-petition claims of 2,330 vendors – in the total amount of approximately $300 million. A creditor that did not receive a critical vendor payment objected to the entry of such an order and appealed. After “all of the critical vendors had been paid and as Kmart’s plan of reorganization was on the verge of approval,” the district court reversed the order on the grounds that “neither [Section] 105(a) nor the ‘doctrine of necessity’” supported the payments. Kmart appealed the district court’s decision to the Seventh Circuit Court of Appeals.

"The critical vendor problem pits the bankruptcy policy of preserving the business and maximizing value against the Bankruptcy Code requirement that similarly situated creditors be treated equally."

The Seventh Circuit Court of Appeals affirmed the district court’s reversal of the bankruptcy court’s critical vendor order. In re Kmart Corp., No. 03-1956, 2004 U.S. App. LEXIS 3397 (7th Cir. Feb. 24, 2004). While the bankruptcy court had authorized the payment under the “doctrine of necessity” on the theory that Kmart needed to pay its suppliers to ensure the uninterrupted supply of trade goods and services that were essential to the preservation of its business, the Seventh Circuit clearly rejected that theory. It left open the possibility, however, that critical vendor payments might be permissible if proven to truly be critical to the debtors’ business.

The critical vendor problem pits the bankruptcy policy of preserving the business and maximizing value against the Bankruptcy Code requirement that similarly situated creditors be treated equally. Under the traditional bankruptcy distribution scheme, all unsecured pre-petition creditors are paid the same percentage of their claims and none are paid until after a chapter 11 plan is confirmed. The critical vendor concept varied this priority scheme to permit debtors to pay some unsecured creditors immediately, in full or in part, on the theory that the payments actually benefited the creditors who did not receive such special treatment by preserving the debtors’ going concern value - thereby increasing the amount of the ultimate payout to all unsecured creditors. For example, if a vendor was essential to the business and refused to continue supplying the debtors absent full payment of its pre-petition claim, then payment was deemed proper to preserve and enhance the value of the business by more than the amount of the payment. While this reasoning has long been applied to justify paying wage claims of employees, foreign suppliers and other unique single-source suppliers, its use has expanded in recent years to the point where debtors in some cases treated a substantial number of continuing suppliers as critical vendors and even used the doctrine to induce suppliers to extend post-petition trade credit. The Kmart order that treated more than 2,300 vendors (out of approximately 4,300 vendors) as critical is an example of this trend.

The Kmart decision signals an end to such liberal use of the doctrine in the Seventh Circuit and, at a minimum, requires a rigorous showing that the creditor truly is critical, that the value of the continued relationship exceeds the amount to be paid, and that the creditor would not continue to deal with the debtor, even on a COD basis, if not paid. Instead of putting the debtor to its proof, the bankruptcy court merely relied on Kmart’s CEO’s representation of the need for the payments. As a result, the Court of Appeals held that the critical vendor order lacked the requisite factual foundation and had to be reversed even if the law permitted some critical vendor payments.

The Court of Appeals expressly rejected several of the legal theories that were asserted by the appellants and had been used in other cases to support the concept of critical vendor payments. First, the Court rejected the view that the doctrine of necessity survived the enactment of the current Bankruptcy Code, stating, “the ‘doctrine of necessity’ is just a fancy name for a power to depart from the Code.” As a practical matter, this statement may have implications that extend far beyond the critical vendor context since the “necessity” argument is used to support many common bankruptcy practices that have no specific statutory support. The Court similarly rejected the view that the bankruptcy court’s general equitable powers under section 105 of the Bankruptcy Code could support the critical vendor order. While the Court does have equitable power to issue orders necessary to implement other Bankruptcy Code provisions, the Court held that such power does not allow it to override the bankruptcy rules regarding priority and distribution. The Court also rejected the view that critical vendor orders could be supported by section 364 of the Bankruptcy Code, which allows the bankruptcy court to award administrative expense priority status for post-petition credit advances. The opinion does not explain its rejection of that theory, but merely calls the argument “unpersuasive.” Finding it “irrelevant, “ the Court also held that the administrative expense provision, section 503 of the Bankruptcy Code, could not support the critical vendor order.

However, the Court suggests that critical vendor orders might be permissible under section 363(b)(1) of the Bankruptcy Code, which allows the court to authorize the use of estate property outside of the ordinary course of business, because paying critical vendors is “a use of property other than in the ordinary course of administering an estate in bankruptcy.” While not deciding whether such an interpretation of section 363 is correct, the Court stated that it is prudent to read section 363 “to do the least damage possible to priorities” and noted that the critical vendor order entered by the bankruptcy court had not been premised on the required factual findings noted above. In what may turn out to be what the Kmart decision is ultimately interpreted to mean, the Court states, “[e]ven if § 362(b)(1) (sic) allows critical-vendors orders in principle, preferential payments to a class of creditors are proper only if the record shows the prospect of benefit to the other creditors.”

So, what should a vendor do if a debtor in the Seventh Circuit, or any other jurisdiction for that matter, seeks to include it on a critical vendor order? Take the money and set it aside! If you learn one thing from Kmart it should be that a court’s entry of a critical vendor order clearly does not guarantee that you will not have to return the money at some point in the future. So take the money, but do not spend it until it is clear that it will not have to be returned. That being said, being included on a critical vendor order, and perhaps actually getting paid in full for your pre-petition claims, is better than the alternative.

© 2004 Greenberg Traurig

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