Critical Vendors Elevating the Low-priority Unsecured Claims of Pre-petition Trade Creditors

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Jun 2002

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This article focuses on <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Payless Cashways Inc., 268 B.R. 543
(Bankr. W.D. Mo. 2001)</a>, and other cases in which courts have approved the
debtor's payment of certain critical vendors' pre-petition unsecured claims, usually in
exchange for an agreement to continue shipping goods on the same credit terms during
the chapter 11 case. As a result, low-priority, pre-petition general unsecured
claims can be converted to higher-priority administrative claims arising from
post-petition credit sales to the debtor. But as demonstrated by <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re CoServ
L.L.C., 273 B.R. 487 (Bankr. N.D. Tex. 2002)</a>, not all courts
will rubber-stamp a debtor's request for preferential treatment of vendors' pre-petition
claims.

<h3>Necessity as a Justification for a Debtor's Payment of Critical Vendors' Pre-petition Claims</h3>

The courts have approved the debtor's payment of certain pre-petition unsecured claims
during the bankruptcy based on the "doctrine of necessity" or the "necessity of payment
rule." This rule was first enunciated by the U.S. Supreme Court in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v.
Logansport C. & S.W.R. Co., 106 U.S. 286 (1882)</a>, and has been
followed by numerous courts. Since the enactment of the Bankruptcy Code, courts
approving such payments have also relied on the bankruptcy court's equitable powers under
§105(a), which allows a bankruptcy court to "...issue any order, process or
judgment that is necessary or appropriate to carry out the provisions of this title."
They have approved the debtor's payment of certain pre-petition unsecured claims when
necessary for a successful reorganization, or to at least preserve the potential of
a rehabilitation of the debtors' business or prevent a liquidation.

For example, certain courts have approved the payment of critical vendors'
pre-petition unsecured claims<a href="#1" name="1a">1</a> and unsecured pre-petition wage and benefit claims.<a href="#2" name="2a">2</a>
However, certain circuit courts of appeal have denied the payment of any pre-petition
unsecured indebtedness prior to confirmation of a chapter 11 plan.<a href="#3" name="3a">3</a>

The necessity doctrine became an exception to the general claims priority rules.
Under these rules, claims are paid based on where they are situated on the claims
priority ladder, and claims in the same class of creditors are entitled to the same
treatment. At the top of the ladder are secured and lien creditors entitled to
payment of their claims from the proceeds of their collateral and a general unsecured
claim for any deficiency.<a href="#4" name="4a">4</a> Next in line are the administrative priority claims of
creditors that provide goods and services to the debtor or trustee, or to whom the
debtor or trustee becomes indebted, during the bankruptcy case.<a href="#5" name="5a">5</a> Creditors holding
lower-level priority claims, such as certain employee wage, salary, benefit, tax and
other claims, are entitled to payment in a designated order of priority from the
debtor's unencumbered assets, after the full payment of all administrative priority claims
and before any payment or other distribution can be made to the debtor's creditors
holding pre-petition general unsecured claims.<a href="#6" name="6a">6</a> Pre-petition unsecured creditors occupy
the lowest creditor rung of the priority ladder and are not entitled to receive any
distribution from the debtor until the higher-priority creditors are paid in full.

<h3>Payless Cashways Payment of Critical Vendors' Pre-petition Unsecured Claims</h3>

The debtor, Payless Cashways Inc., operated 117 stores and was in the business
of selling lumber and wood products and other building materials to both contractors and
individuals. When Payless filed its chapter 11 (during the peak summer season),
it lacked sufficient wood and ancillary products to satisfy customer needs. Payless also
lacked the cash and trade credit to purchase additional product. As a result, Payless
lost significant sales.

Payless decided to seek court approval of the payment of the pre-petition unsecured
claims of certain of its critical lumber vendors. Critical lumber vendors receiving
payment of their pre-petition claims had to agree to extend unsecured credit to
Payless, based on credit terms at least as favorable as the standard industry terms,
for up to one year after confirmation of a chapter 11 plan. Participating vendors
would be granted an administrative priority claim for the amount of any unpaid
post-petition credit extended to Payless under §§503(b) and 507(a) of the
Bankruptcy Code.

The court approved the payment of the pre-petition unsecured claims of Payless's
critical lumber vendors based on §364(b) of the Bankruptcy Code rather than
§105(a). Section 364(b) gives the court broad authority to approve credit
arrangements out of the ordinary course of business and grant the credit provider an
allowed administrative expense claim. The court recognized that Payless could not induce
suppliers to extend credit based on the bare promise of an administrative claim that
is subject to the prior security interest of Payless's pre-petition lender. Payless had
to offer something else to obtain trade credit: the payment of critical vendors'
pre-petition claims.

The court relied on the following: (1) the creditors' committee approved the
arrangement; (2) the critical lumber vendors had refused to extend credit and ship
the product in the quantities and within the time frames required by Payless unless
their pre-petition claims were paid; (3) the amount paid to the critical vendors
was just two percent of Payless's pre-petition debt; (4) the continued delivery of
goods by Payless's critical lumber vendors was critical to the survival of Payless's
business; and (5) the transactions between Payless and its critical vendors were at
arms' length.

The court also held that critical vendors receiving payment of their pre-petition
unsecured claims cannot be compelled to disgorge the payments as preferences in the
event of a conversion of the debtor's chapter 11 case to a chapter 7 liquidation.
Section 549 of the Bankruptcy Code prohibits a debtor's payment of pre-petition
claims unless the payment is otherwise authorized under the Bankruptcy Code or by an
order of the bankruptcy court. Critical vendors should not be forced to disgorge
payments of their pre-petition claims received pursuant to a court order, particularly
where they were induced to continue doing business with the debtor on credit terms in
reliance upon such court-approved payments.

The court in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Wehrenberg Inc., 260 B.R. 468 (Bankr. E.D.
Mo. 2001)</a>, also approved the debtor's payment of the pre-petition unsecured claims
of several vendors. The vendors had threatened to stop delivery of films to the debtor
(an operator of a chain of movie theaters) unless their pre-petition claims were
paid. The court considered them critical vendors and approved the payment of their
pre-petition claims as necessary for the debtor's continued operation.

<h3>The Kmart Critical Vendor Orders</h3>

The bankruptcy court in Kmart Corp.'s chapter 11 case recently approved orders
authorizing Kmart's payment of all or a portion of the pre-petition claims of certain
critical vendors.<a href="#7" name="7a">7</a> One of them, Fleming Companies Inc., a food distribution
company, had a pre-petition claim of approximately $76 million against Kmart. Fleming
is Kmart's largest supplier, providing substantially all of the food and consumable
products in Kmart's stores as well as the infrastructure for Kmart's food and consumables
businesses. A second critical vendor is Handleman Co., Kmart's sole music vendor,
which provides the infrastructure for Kmart's music business and had a pre-petition
unsecured claim of approximately $64 million. Kmart's egg and dairy vendors are also
critical vendors since their goods attract shoppers to Kmart's stores. They are also a
critical source of supply who might not survive if their pre-petition claims were not
paid. Newspapers, printers, paper suppliers and ad production businesses that are
necessary for Kmart's weekly newspaper circular program are also critical vendors.

Kmart also obtained court approval for the payment of the pre-petition claims of
certain liquor vendors. Kmart argued that these vendors are precluded by state law from
extending credit beyond a fixed number of days and would have otherwise been precluded
from continuing to do business with Kmart.

Kmart's payment of critical vendors' pre-petition claims is conditioned on their
agreement to continue selling goods and/or providing services to Kmart on the same
trade terms they had offered to Kmart on a historical basis prior to the chapter
11 filing ("customary trade terms"), or on such other terms that are at least
as favorable to Kmart. Kmart may require participating critical vendors to sign an
agreement. The agreement includes, among other terms, confirmation of the amount
of the critical vendors' pre-petition claims, obligating critical vendors to continue
to extend credit to Kmart based on customary trade terms for two years, and binding
all of the terms of the court order approving Kmart's payment of their pre-petition
claims. Critical vendors also must agree to forego exercising any rights and
remedies (such as reclamation or stoppage of delivery claims) with respect to,
and/or enforcing any liens that secure payment of, their pre-petition claims.
Finally, participating vendors that fail to comply with the bankruptcy court order
authorizing the payment of their pre-petition claims and/or their agreements with
Kmart may be forced to disgorge the payment or have it offset against unpaid
invoices from their post-petition shipments of goods.

<h3>The CoServ L.L.C. Decision</h3>

The court in In re CoServ L.L.C. made clear that it would not rubber-stamp
a debtor's request to pay the pre-petition claims of certain favored vendors during
the chapter 11 and would carefully scrutinize such requests. A debtor seeking the
pre-chapter 11 plan payment of a vendor's pre-petition claim had to satisfy the
following three requirements:

<ul>
<li>The payment is indispensable to the debtor's business. A sole supplier of a
given product would satisfy this element of the test;

</li><li>Non-payment of the claim risks probable harm or eliminates an economic advantage
disproportionate to the amount of the claim; and

</li><li>There is no practical or legal alternative to payment of the claim.
</li></ul>

The court stated that a critical vendor cannot use its leverage to extort the
payment of its pre-petition claim, particularly where the debtor and vendor had
entered into a contract pre-petition and the debtor was continuing to perform under
the contract post-petition. Such "economic blackmail" may violate the automatic stay
under §362(a) of the Bankruptcy Code. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Structurlite Plastics Corp.,
86 B.R. 922, 932 (Bankr. S.D. Ohio 1988)</a>.

The court applied this three-point test to approve the payment of the pre-petition
claims of two vendors and deny the payment of the pre-petition claims of five
vendors. A vendor that continues to do business with a debtor if the vendor received
a pre-payment, deposit or other assurance of payment would not qualify. A vendor
also would not qualify where the debtor could obtain the same goods elsewhere.

<h3>Conclusion</h3>

More bankruptcy courts have invoked the necessity doctrine to approve the payment of
certain critical vendors' and other creditors' pre-petition unsecured claims during their
customer's chapter 11 case. However, a court may not necessarily rubber-stamp a
debtor's request and may instead require proof that the payment is indispensable to the
success of a debtor's case.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Just For Feet Inc., 242 B.R. 821 (D. Del. 1999)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Wehrenberg, 260 B.R. 468 (Bankr.
E.D. Mo. 2001)</a>. <a href="#1a">Return to article</a>

<a name="2">2</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Equalnet Communications Corp., 258 B.R. 368 (Bankr. S.D. Tex. 2000)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re UNR Industries
Inc., 143 B.R. 506, 519-20 (Bankr. N.D. Ill. 1992)</a>, rev'd. on their grounds; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Industries Inc. v.
Bloomington Factory Workers, 173 B.R. 149, 158-59 (Bankr. N.D. Ill. 1994)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Gulf Air Inc., 112 B.R.
152 (Bankr. W.D. La. 1989)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Ionosphere Clubs Inc., 98 B.R. 174 (Bankr. S.D.N.Y. 1989)</a>. <a href="#2a">Return to article</a>

<a name="3">3</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Committee of Equity Sec. Holders v. Mabey, 832 F 2d. 299 (4th Cir. 1987)</a>, cert. denied, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
v. Official Committee of Equity Sec. Holders of M.H. Robins Co. Inc., 485 U.S. 962, 108 S. Ct. 1228, 99 L.
Ed. 2d 428 (1988)</a> (creation of emergency treatment fund for Dalkon Shield claimants prior to confirmation of plan violated Bankruptcy
Code and could not be justified as an exercise of court's equitable powers under §105(a); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re FCX Inc., 60 B.R. 405
(E.D.N.C. 1986)</a> (court denied payment of pre-petition payroll taxes, expenses and other unsecured claims in the absence of grounds
for subordinating other unsecured claims, such as inequitable conduct by remaining creditors). See, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… the Matter of Oxford Management
Inc., 4 F. 3d 1329, 1334 (5th Cir. 1993)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… the Matter of B&W Enterprises Inc., 713 F. 2d 534,
535-37 (9th Cir. 1983)</a>. <a href="#3a">Return to article</a>

<a name="4">4</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §506(a)</a>. <a href="#4a">Return to article</a>

<a name="5">5</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §507(a)</a>. <a href="#5a">Return to article</a>

<a name="6">6</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §507(a)(2)-(9)</a>. <a href="#6a">Return to article</a>

<a name="7">7</a> In re Kmart Corp. et al., Chapter 11, Case No. 02-B-02474 (SPS) (Bankr. N.D. Ill. Jan. 25, 2002)
and (Bankr. N.D. Ill. Feb. 13, 2002). Both orders are subject to pending appeals. <a href="#7a">Return to article</a>

Journal Authors

Bruce S. Nathan

Journal Date

Saturday, June 1, 2002 - 12:00

Bankruptcy Rule

2002