Caveat Vendor Doctrine of Necessity Down But Not Out

Journal Issue

Apr 2004

Column Name

Journal HTML Content

Editor's Note:

Also see the related article by H. Bradley Staggs.

</blockquote>

A ground-breaking decision by the Seventh Circuit Court of Appeals will likely cause debtor's counsel to rethink
first-day critical vendor orders and the factual basis employed to support such an application. In Kmart's chapter 11
filing in 2002, the debtor filed an application to pay in full the pre-petition claims of 2,330 vendors which, in its
judgment, constituted critical vendors requiring payment in full. The aggregate payment to such pre-petition
vendors was approximately $300 million, with the payment coming from Kmart's debtor-in-possession (DIP)
financing.

The bankruptcy judge entered the critical-vendor order just as Kmart proposed it, without notifying any disfavored
creditors or taking any supporting evidence. The order did not contain any legal analysis for the basis of the order,
though it did cite §105(a).

An immediate appeal was taken from the bankruptcy court's order by Capital Factors Inc., one of the 45,000
creditors or vendors deemed not critical. When Kmart's reorganization plan was confirmed, these "disfavored"
unsecured creditors received approximately $0.10 on the dollar, payable for the most part from the reorganized
debtor's stock. On appeal, the U.S. District Court reversed the bankruptcy court's order based on its conclusion that
invocation of §105(a) of the Bankruptcy Code was not warranted and that the doctrine of necessity was not
applicable.

In addressing the issues raised on appeal, Judge Easterbrook's opinion for the Seventh Circuit turned first to the
contention that, by the time the district court acted, it was too late to reverse the action of the bankruptcy judge.
Relief could not be granted because the "money had changed hands and...cannot be refunded." In making it clear
that this controversy was far from moot, and that the judicial order entered by the bankruptcy court could be
effectively remedied, the Seventh Circuit specifically stated that "reversing preferential transfers is an ordinary
feature of bankruptcy practice, often continuing under a confirmed plan of reorganization...if the orders in question
are invalid, then the critical vendors have received preferences that Kmart is entitled to recoup for the benefit of all
creditors."<a href="#1" name="1a">1</a>

A procedural hurdle raised by Handleman Co., an intervening appellant, was the fact that this critical vendor did
not receive notice of the appeal and was thus not bound by the district court's order. Rule 8001(a)(2) requires that
the notice of appeal name "all parties to the judgment, order or decree." The court quickly disposed of this
procedural objection by holding that, at the time the critical vendor order was entered, the only party to the
proceeding was Kmart. In explaining the legal position of Handleman as a creditor, the court simply stated that
"Handleman was not a 'party' to the critical-vendor order." The court went on to explain that "there is no
constitutional obligation to make every creditor a party to every contested matter in the bankruptcy. As a rule, a
trustee or debtor-in-possession represents the interest of many stakeholders. Kmart vigorously represented the
interest of Handleman and the other vendors Kmart deemed "critical."

[E]mployment of §363(b)(1) might well pass muster if...the debtor can establish that "paying the critical vendors would enable a successful reorganization and make even the disfavored creditors better off...."
</center></big>
<hr>
</blockquote></blockquote>

Addressing the bankruptcy court's power under §105(a), the court stated that "the power conferred by §105(a) is one
to implement rather than to override." In support of this conclusion, the court relies on several cited cases, including
Official Committee of Equity Security Holders vs. Mabey, 832 F. 2nd (299 4th Cir. 1987). When entering an order
within the broad parameters of §105(a), the relief granted must be predicated on an existing section of the
Bankruptcy Code or other statute. The problem with any payment made to critical vendors for pre-petition claims is
that such payments do not readily relate to any existing Code sections relied on by appellants, namely §§364(b) and
503. The real turning point in the court's legal analysis is §363(b)(1), which states that "the [trustee] or [DIP], after
notice and a hearing, may use, sell or lease, other than in the ordinary course of business, property of the estate."
The court goes on to state, however, that "we need not decide whether §363(b)(1) could support payment of some
pre-petition debts, because this order was unsound no matter how one reads §363(b) (1)."

The real lesson to debtor's counsel is found in the court's analysis that employment of §363(b)(1) might well pass
muster if and to the extent the debtor can establish that "paying the critical vendors would enable a successful
reorganization and make even the disfavored creditors better off...." In addition, the court makes it clear that in
addition to applying this test, there should be a showing "that the disfavored creditors will be as well off with
reorganization as with liquidation—a demonstration never attempted in this proceeding—but also that the
supposedly critical vendors would have ceased deliveries if old debts were left unpaid while the litigation
continued."

The court justifies its legal position by acknowledging the proposition of the business world that "some supposedly
critical vendors will continue to do business with the debtor because they must. They may, for example, have
long-term contracts, and the automatic stay prevents these vendors from walking away as long as the debtor pays for
new deliveries." It seems likely that the "marketplace" mentality will adjust and that debtors' counsel should be
prepared to pursue an evidentiary showing, in keeping with Judge Easterbrook's requirements of "real survival
necessity."

This decision, in line with the rationale of Mabey, makes it clear that the proper invocation of §105(a) will require
something more than conclusory statements. In order to secure relief in those situations where a critical vendor is
under no continuing contractual obligation to supply merchandise vital to the debtor's ongoing business needs and
has made it clear that it will not continue to do business because of a preexisting and non discriminatory business
decision,<a href="#2" name="2a">2</a> then the debtor will be required to meet the requirements set forth by this decision—namely, that
payment of the pre-petition claim will benefit those non-critical vendors so that they "will be as well off with
reorganization as with liquidation...." In the real world of reorganization, this will necessitate a critical-vendor
analysis by the debtor that narrows down those candidates who might justify this extraordinary treatment.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Although as a matter of legal principle, the reference to preferential transfers seems inapplicable based on the fact that the payments made appeared to be solely post-petition transfers subject to the provisions of §549(a). <a href="#1a">Return to article</a>

<a name="2">2</a> A lesson might well be learned from the overly aggressive approach taken by a creditor in Sportfame of Ohio Inc. v. Wilson Sporting Goods Co. (In re Sportfame of Ohio Inc.), 40
B.R. 47 (Bankr. N.D. Ohio 1984). In this case, Wilson, a critical vendor of the debtor, had discontinued sales to Sportfame pre-petition because of nonpayment of its claim.
Upon filing its chapter 11, the debtor requested resumption of critical deliveries on a COD basis, but Wilson refused unless the pre-petition debt was paid. Because this latter
action by Wilson was held, in the opinion of the bankruptcy court, to violate §362(a)(6), namely an attempt to collect a pre-petition debt, the bankruptcy court, exercising its
powers under §105(a), entered an injunction requiring Wilson to resume shipments and required the debtor, in turn, to pay cash for all such deliveries. Clearly, this is a most
unique approach to a common problem. <a href="#2a">Return to article</a>

Journal Authors

Roger M. Whelan

Journal Date

Thursday, April 1, 2004 - 12:00

Bankruptcy Rule

2004