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A debtor filing for bankruptcy protection under Chapter 11 usually retains control of its company and continues to operate its business while developing a plan to reorganize and restructure. One of the first consequences a Chapter 11 debtor is likely to face is the refusal of its vendors to provide goods and services on credit – payment will likely be required in full upon delivery. The inability to pay vendors who provide inventory or other property that is crucial to the debtor’s operations may precipitate a rapid demise of the debtor, effectively defeating any chance for reorganization. To avoid this result, debtors often request authorization to pay the prepetition obligations of certain vendors who provide goods or services deemed critical to the operation of the debtors’ business. While the Bankruptcy Code’s scheme for paying unsecured creditors does not grant priority to unsecured prepetition claims, some bankruptcy courts have tempered the statutory scheme by relying on equitable powers derived from Section 105(a) of the Bankruptcy Code, which states that a bankruptcy court “may issue any order, process or judgment that is necessary or appropriate to carry out the provisions” of the Bankruptcy Code (emphasis added). Bankruptcy courts in many jurisdictions, including courts within the 3rd U.S. Circuit Court of Appeals, have exercised this equitable power to authorize a debtor’s payment of prepetition claims to vendors that are deemed to be “essential” to the debtor’s survival. Known as the “necessity of payment” rule, or the “doctrine of necessity,” this judicially conceived rule provides a mechanism for the payment of certain unsecured prepetition debt. Not surprisingly, unsecured creditors who do not provide critical services to a debtor argue that permitting such payments contravenes the Bankruptcy Code’s statutory scheme. Exercise of this equitable power was recently challenged in the U.S. District Court for the Northern District of Illinois. In Capital Factors, Inc. v. Kmart Corp., 291 B.R. 18 (N.D. Ill. 2003), a factoring agent that had purchased accounts receivable from Kmart challenged the bankruptcy court’s authority to permit Kmart to pay “critical” vendors for prepetition claims prior to confirmation of its reorganization plan. On the same day that Kmart filed its Chapter 11 petition, it filed two motions seeking authority to pay certain vendors for obligations that were incurred during the prepetition period, and Capital Factors objected. The bankruptcy court heard evidence on the motions and objection and, after requiring that Kmart provide a list of the specific vendors that would be paid, granted the motions. Less than one month later, Kmart filed two additional motions, one requesting authority to pay the issuers of prepetition letters of credit, and another requesting authority to pay the prepetition claims of certain liquor vendors. A-gain, the bankruptcy court, relying on its equitable authority under Section 105, granted the motions over the objection of Capital Factors, noting that Kmart had presented a “good business justification” for making the payments. Capital Factors appealed each of the four orders to the district court, questioning whether the bankruptcy court had either the statutory or equitable authority to allow Kmart to selectively pay prepetition unsecured trade claims before plan confirmation. Kmart argued that not only was the bankruptcy court justified in exercising such equitable power, the appeal was also rendered moot because Kmart had already paid a substantial portion of the prepetition claims to the critical vendors. The district court rejected Kmart’s arguments. Authority Under Section 105 The Capital Factors court first addressed the scope of a bankruptcy court’s equitable authority under Section 105, noting that this is the only source from which it believed the “doctrine of necessity” implicitly arises. The court then examined the way that other courts have interpreted the scope of this authority, beginning with the precedent of its own circuit. The Capital Factors court first noted that the 7th U.S. Circuit Court of Appeals has limited the scope of a bankruptcy court’s authority under Section 105 to actions that are necessary to enforce existing provisions of the code. Any actions that would have the effect of expanding the Bankruptcy Code would, therefore, not be actions a bankruptcy court is authorized to take. Applying this rule to the circumstances before it, the district court observed that the Bankruptcy Code’s priority scheme for the payment of claims does not confer priority status on claims of creditors who are considered to be critical or integral vendors. Thus, the bankruptcy court’s allowing these payments effectively elevated the unsecured vendors’ claims over those of other unsecured creditors and altered the Bankruptcy Code’s priority scheme. Pursuant to the 7th Circuit’s admonition, the district court further concluded that the bankruptcy court’s actions had, therefore, effected an impermissible expansion of the Bankruptcy Code. The Capital Factors court acknowledged that whether a bankruptcy court’s equitable power includes authorization of critical vendor payments is not well settled, noting that “many bankruptcy courts and a handful of district courts” have found this application of a bankruptcy court’s authority to be valid. However, the court found more persuasive the fact that circuit courts of appeal in the 4th, 5th and 9th circuits, in addition to the 7th Circuit, have held that no authority to permit such payments exists. The court concluded its analysis by stating that although allowing a debtor to pay critical vendors may allow the debtor to “minimize disruptions” in operating its business, the equitable power afforded by Section 105 simply does not permit a bankruptcy court to authorize payments to unsecured vendors, whether or not they provide critical goods and services. Equitable Mootness In addition to arguing that the bankruptcy court had acted within its proper authority, Kmart argued that the court should affirm the payments because (1) Capital Factors did not seek a stay of the bankruptcy court’s rulings, and (2) Kmart had already paid the vendors. Kmart pointed out that requiring that the funds be returned would be inequitable, since the third parties who received the payments had already acted in reliance on them. Further, Kmart asserted that it might have to commence lawsuits to recover the funds, posing an even greater financial burden on the estate, and potentially paralyzing Kmart’s operations. The Capital Factors court rejected both of these arguments. After quickly dismissing the first argument by noting that a stay would not likely have been granted, the court noted that the ultimate question to be answered was whether it would be “prudent and fair” to undo the bankruptcy court’s ruling. Concluding that it was not too late to order that the monies be returned, the court discounted the likelihood that lawsuits would be needed, noting that Kmart had cited no case law suggesting that a bankruptcy court would be without authority to order the return of the monies to the estate. Capital Factors Implications Particularly because it was decided in the bankruptcy case of a large retail company with significant requirements to maintain its inventory, Capital Factors is important to Chapter 11 debtors. The manner in which the district court methodically rejected the doctrine of necessity, supported by decisions of courts of appeal from various circuits, should be alarming to debtors in possession that are trying to continue operations while reorganizing. The inability to meet the demands of vendors that require cash payments might go beyond the “disruption” of operations to the effective destruction of a debtor that is trying to reorganize its business. From a Chapter 11 creditor’s perspective, the decision will most probably encourage “non-critical” unsecured creditors to more readily challenge such motions. In any event, it is difficult to ignore the district court’s conclusion that permitting any unsecured creditor to be paid prior to the plan’s confirmation contravenes the Bankruptcy Code’s statutory direction. When the likely reactions to Capital Factors of all parties are considered as a whole, the potential effect of precluding debtors from paying critical vendors could be devastating to debtors attempting to reorganize. It is notable that in the 3rd Circuit, the U.S. District Court for the District of Delaware has approved such payments, holding in In re Just for Feet, Inc., 242 B.R. 821 (D. Del. 1999) that Section 105 did grant the bankruptcy court authority to allow for the payment of vendors who provided critical inventory for a chain of retail stores.

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