Seventh Circuit Rejects The Doctrine Of Necessity.

"First day" motions accompanying a chapter 11 debtor's bankruptcy petition routinely include an application for authority to pay the pre-bankruptcy claims of vendors and other creditors without whom the debtor could not continue to operate its business. Many bankruptcy judges grant such "critical vendor" motions by relying upon a principle commonly referred to as the "necessity of payment" rule or "the doctrine of necessity." Developed in connection with railroad reorganizations under the Railway Labor Act (a predecessor statute to the Bankruptcy Code), the doctrine was intended to ensure the continued delivery of supplies or services considered essential to the reorganization efforts of railways. It provided that current and necessary operating expenses incurred within six months of the filing of a railroad reorganization case would be entitled to priority in payment over the claims of other general unsecured creditors.

The problem is that the rule, which is now codified in section 1171(b) of the Bankruptcy Code, only applies to railroad bankruptcies. In other reorganizations, the Bankruptcy Code contemplates that claims asserted by all unsecured pre-petition creditors will be satisfied, in whole or in part, at the conclusion of a chapter 11 case in accordance with the terms of a confirmed plan of reorganization. This is in keeping with one of the Code's primary objectives - equality of distribution among similarly situated creditors. Payment to creditors, whether "critical" or not, at the outset of a case is clearly inconsistent with this objective. It alters the priority scheme for unsecured claims set forth in the Bankruptcy Code and (perhaps) unfairly prefers a handful of unsecured creditors over those forced to wait until the end of the case.

Turmoil In The Courts

Undaunted by the absence of express authority, many bankruptcy courts justify deploying the doctrine as an exercise of their broad powers as courts of equity under section 105(a) of the Bankruptcy Code. That section provides that "[t]he court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of" the Bankruptcy

Code. Recognizing that the success of a chapter 11 reorganization hinges in large part on the debtor's ability to avoid, as nearly as possible, significant disruption in its business operations, these courts authorize the debtor to pay the claims of pre-petition vendors at the outset of a case, so long as the debtor demonstrates that a vendor is "critical" and the payment is necessary.

Unfortunately, no less than five federal Circuit Courts of Appeal have either held or expressed the view that neither the doctrine of necessity nor section 105(a) authorizes the payment of pre-petition claims outside of a plan of reorganization. The Ninth Circuit was the first to do so in In re B & W Enterprises Inc., where it ruled that the doctrine of neces- Inc sity is confined to railroad cases, observing that it is "unwise to tamper with the statutory priority scheme devised by Congress." That same year, the Sixth Circuit noted (but did not rule) in Crowe & Associates Inc. v. Bricklayers & Masons Union Local No. 2 (In re Crowe & Associates, Inc.), that a Inc.) bankruptcy court cannot authorize a debtor to pay pre-bankruptcy claims prior to confirmation of a plan, even to avoid a strike that would "shut down the debtor's operations."

Four years later, the Fourth Circuit ruled that section 105(a) does not authorize a bankruptcy court to permit preplan payment of pre-petition unsecured claims in Official Committee of Equity Holders v. Mabey, reversing a bankrupt- Mabey cy court order that established an emergency fund to pay the medical expenses of Dalkon Shield victims prior to confirmation of the debtor's chapter 11 plan. The Fifth Circuit reached the same conclusion in Matter of Oxford Management, Inc. when it ruled that the bankruptcy court improperly used its equity powers to direct a chapter 11 debtor-sponsoring broker to pay pre-petition commissions owed to associate brokers because the court elevated the status of the associate brokers above that of other general unsecured creditors and deviated from the pro rata scheme of distribution envisioned by the Bankruptcy Code.

Limitations on the scope of a bankruptcy court's equitable powers have also been addressed by the U.S. Supreme Court. In Norwest Bank Worthington v. Ahlers, the High Court held that "whatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of the Bankruptcy Code." More recently, the Supreme Court ruled in a tandem of cases ( United States v. Reorganized CF & I Fabricators of Utah, Inc. and United States v. Noland), that Noland a bankruptcy court cannot use its equitable powers to reorder the priority scheme created by the Bankruptcy Code. These rulings have been widely interpreted to mean that section 105(a) does not allow a bankruptcy court to override the explicit mandates of other provisions of the Bankruptcy Code.

Notwithstanding rulings from higher up, the practice continues. Many commentators and practitioners ascribe the intransigence of bankruptcy judges on this issue to the fact that, as the courts presiding over chapter 11 cases on a dayby- day basis, bankruptcy courts are much more aware of the practical realities affecting debtors, creditors and other participants in a case. If the debtor's inability to continue operating because key creditors refuse to continue doing business with it could lead to a meltdown, many bankruptcy courts will authorize the debtor to pay their claims at the beginning of a case. These courts reason that authorizing the payment of pre-bankruptcy claims outside of a plan represents an appropriate exercise of their equitable power to ensure that a chapter 11 debtor at least has a chance to reorganize successfully.

Spotlight On Kmart

The Seventh Circuit recently had an opportunity to weigh in on the viability of the doctrine of necessity in In re Kmart Corporation. As part of its "first day" motions, chapter 11 Corporation debtor Kmart sought authority in January of 2003 to pay nearly $300 million in pre-petition debts to 2,330 domestic and foreign suppliers, claiming that the payments were necessary to maintain relationships essential to its continued operation and reorganization. Kmart relied upon the doctrine of necessity and Bankruptcy Code section 105(a) as authority for the payments. Capital Factors, Inc., the factoring agent for Kmart's apparel suppliers (and an unsecured creditor of Kmart to the tune of $20 million), objected to the motion. Bankruptcy Judge Susan Pierson Sonderby concluded that the suppliers "are necessary to keep this business going as a going concern" and authorized the payments. She subsequently authorized Kmart to pay issuers of pre-petition letters of credit and the pre-bankruptcy claims of certain liquor vendors, reasoning that the L/C issuers "are integral to the reorganization" and that "there is a good business justification" from page 4 for paying the pre-bankruptcy claims of Kmart's liquor vendors. Capital Factors appealed all of the bankruptcy court's orders.

The district court reversed. Recognizing that there is a split in the courts regarding whether section 105(a) authorizes a bankruptcy court to permit the payment of unsecured claims outside of a plan of reorganization, District Judge John F. Grady held that "we cannot ignore the Bankruptcy Court's statutory scheme of priority in favor of 'equity.'" The court acknowledged that application of the rule of necessity through section 105(a) "is well intended and may even have some beneficial results, in that pre-plan payment of certain pre-petition claims allows the debtor to minimize disruptions in doing business, and thus may further reorganization." Still, Judge Grady concluded that because Congress has not chosen to codify the doctrine or to otherwise permit pre-plan payment of unsecured claims, such payments "simply are not authorized by the Bankruptcy Code."

Kmart appealed to the 7th Circuit. While the appeal was pending, Kmart confirmed a plan of reorganization under which its 45,000 "non-critical" unsecured creditors received approximately ten cents on the dollar for their claims, mostly in the form of stock of the reorganized Kmart. Notwithstanding the district court's ruling, Kmart asked only one of its suppliers, Handleman Co., to return the funds paid to it as a critical supplier (approximately $49 million). However, Kmart's chapter 11 plan expressly reserved the right to recover any payments made to creditors to the extent that they proved to be unauthorized.

The Seventh Circuit affirmed the district court's ruling in February of 2004. At the outset, it rejected the vendors' contention that it was too late to recover the payments. Kmart's confirmed plan, the court emphasized, specifically provided that Kmart had the right to sue to recover any unauthorized payments made before or during its bankruptcy proceedings. The court also found that while the suppliers may have relied on the payments in agreeing to continue to deal with Kmart, they did not do so to their detriment - all vendors were paid in full for post-petition goods and services.

The Court of Appeals then turned to the merits. Like every other circuit court that has addressed this issue, the 7th Circuit ruled that section 105(a) does not create discretion to set aside the Bankruptcy Code's rules about priority and distribution. Observing that "[a] 'doctrine of necessity' is just a fancy name for a power to depart from the Code," the court emphasized that "[o]lder doctrines [like the rule of necessity] may survive as glosses on ambiguous language enacted in 1978 or later, but not as freestanding entitlements to trump the text." Next, it examined the Bankruptcy Code for specific authority to pay pre-petition claims in the manner that Kmart had been authorized by the bankruptcy court.

It found none. According to the court, section 363(b)(1), which authorizes a trustee or chapter 11 debtor-in-possession, with court approval, to use property outside the ordinary course of business, is the most promising alternative. However, the court found that it need not decide whether section 363(b)(1) could support payment of some pre-petition debts "because this order was unsound no matter how one reads" that provision. It explained that Kmart never even attempted to offer any evidence to support the very premise of its critical vendor motion - namely, that the supposedly critical suppliers would have ceased deliveries if old debts were left unpaid. According to the court, some of Kmart's vendors were obligated to continue supplying Kmart because the automatic stay precluded them from terminating supply contracts that were in force as of the bankruptcy filing date. In addition, the court noted, Kmart never explored alternative means of assuring vendors that it would pay for new deliveries on a current basis, such as a standby letter of credit. Finally, the 7th Circuit faulted the bankruptcy court's determination because it was unsupported by findings that any vendor would have stopped doing business with Kmart if not paid for pre-petition deliveries, that discrimination among unsecured creditors was the only way to facilitate a reorganization or that Kmart's other creditors were at least as well off as they would have been had the critical vendor order not been entered.

Analysis

The impact of the 7th Circuit's decision on Kmart's reorganization is unclear. Presumably, absent further appeal to the Supreme Court, reorganized Kmart must ask its critical vendors to return what they were paid at the inception of the case (or sue to recover the money) so that those payments, which were funded by Kmart's post-petition lenders, can be administered under Kmart's plan. It remains to be seen whether the plan's provisions adequately account for the contingency now realized in the 7th Circuit's ruling.

Every circuit court of appeals called upon to pass on the propriety of the doctrine of necessity and/or section 105(a) as authority for paying critical vendors at the inception of a bankruptcy case has ruled that neither is a legitimate basis for authorizing the payment of pre-petition debts. The repercussions of Kmart in other chapter 11 cases may be signifi- cant. Suppliers may simply take their business elsewhere and refuse to deal with a company whose prospects for rehabilitation and ongoing business vitality are uncertain. Or perhaps not. Another possible explanation for the insistence of vendors and certain other "critical" creditors upon payment of their pre-petition claims as a quid pro quo for continuing to do business with a chapter 11 debtor is that they know they can get it (at least in some venues, such as the popular New York and Delaware bankruptcy courts). Whether these creditors can readily take their business elsewhere, or would not be willing to wait in line with other pre-petition creditors to get paid, is a matter of pure speculation in some cases. It depends in large part on the nature of the business involved, the products or services provided by the vendor, the relationship between the debtor and the vendor and prevailing conditions in the industry and/or market.

Kmart does contain a glimmer of hope. By declining to decide whether section 363(b)(1) might not be a predicate for authorizing critical vendor payments in an appropriate case, the Seventh Circuit provided a roadmap for making the case that such payments may be justified where the debtor adequately demonstrates that they are indeed critical to its prospects for a successful reorganization.

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References

In re Kmart Corp., 359 F.3d 866 (7th Cir. 2004).

In re B & W Enterprises Inc., 713 F.2d 534, 537 (9 Inc. th Cir. 1983).

Crowe & Associates Inc. v. Bricklayers & Masons Union Local No. 2 (In re Crowe & Associates, Inc.), 713 F.2d 211 (6th Cir. 1983).

Official Committee of Equity Holders v. Mabey, 832 F.2d 299 Mabey (4th Cir. 1987).

Matter of Oxford Management, Inc., 4 F.3d 1329 (5 Inc. th Cir. 1993).

Norwest Bank Worthington v. Ahlers, 485 U.S. 197 (1988).

United States v. Reorganized CF & I Fabricators of Utah, Inc., 518 U.S. 213 (1996).

United States v. Noland, 517 U.S. 535 (1996).

In re Chicago, Milwaukee, St. Paul & Pac., R.R. Co., 791 F.2d Co. 524 (7th Cir. 1986).

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