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In the past several years in large bankruptcy cases, in first day orders, the debtor seeks permission to pay certain pre-petition claims of “critical vendors” immediately and in full. The theory behind the granting of such a status is that the debtor asserts that the suppliers may be unwilling to do business with a customer that is behind in payments, and, if it cannot obtain the merchandise that its own customers have come to expect, the firm may be unable to carry on, injuring all of the creditors. In the past year, several opinions have come down and criticized and/or stricken the concept of critical vendor. The most recent case involving this issue is In re Kmart Corp. In this opinion, the 7th U.S. Circuit Court of Appeals clearly raises doubt as to the viability of this concept. The facts in this case are rather standard in the area of critical vendors. On the first day of its bankruptcy, Kmart sought permission to pay immediately, and in full, the pre-petition claims of all critical vendors. The rationale as described above is that if Kmart did not pay these vendors, these vendors would not supply a product to Kmart. The ultimate effect of this would be that Kmart could not continue to provide quality merchandise to its customers, and the company would fail. The bankruptcy judge on the first day entered the critical vendor orders, just as Kmart proposed it. The bankruptcy court did not notify any of the disfavored creditors, nor was there any testimony other than representations of debtor’s counsel. Furthermore, the bankruptcy court did not make any finding of fact that the disfavored creditors would gain or come out even if the order was granted. In addition, the bankruptcy court order declared that the relief Kmart requested was open-ended permission to pay any debt to any vendor it (Kmart) deemed critical in the exercise of unilateral discretion, provided the vendor agreed to furnish goods on “customary trade terms” for the next two years. Furthermore, the court declared that this was “in the best interests of the debtors, their estates and their creditors.” The court did not explain why, nor did it contain any legal analysis other than to cite Chapter 11 U.S. Code Section 105(a). The court of appeals stated that the proposition in granting critical vendor status implies, and that the debtor must prove and not just allege two things: That but for the immediate full payment, vendors would cease dealing; and that the business will gain enough from continued transactions with the favored vendors to provide some residual benefit to the remaining, disfavored creditors, or at least leave them no worse off. Kmart used its authority to pay in full pre-petition debts to 2,330 suppliers, which collectively received about $300 million. Kmart had received $2 billion in new credit financing at the time of the bankruptcy. Another 2,000 or so vendors were not deemed “critical” and were not paid. They and 43,000 additional unsecured creditors eventually received about 10 cents on the dollar, mostly in stock of the reorganized debtor. A little more than 14 months after the initial order, after all the critical vendors had been paid and as Kmart’s plan of reorganization was on the verge of approval, the district court judge reversed the order authorizing payment. He concluded that neither Section 105(a) nor a “doctrine of necessity” supports the orders. Debtor insists that by the time the district court entered its order, it was too late. Money had changed hands and cannot be refunded. The court of appeals response to that was, why not? Reversing preferential transfers is an ordinary feature of bankruptcy practice, often continuing under a confirmed plan of reorganization. The court of appeals stated that 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. Confirmation of a plan does not stop the administration of the estate, except to the extent that the plan itself so provides. The court went on to state that several provisions of the code do forbid revision of transactions completed under judicial auspices. For example, the DIP financing order, issued contemporaneously with the critical-vendors order, is sheltered by 11 U.S.C. Section 364(e): “The reversal or modification on appeal of an authorization under this section to obtain credit or incur debt, or of a grant under this section of a priority or a lien, does not affect the validity of any debt so incurred, or any priority or lien so granted, to an entity that extended such credit in good faith, whether or not such entity knew of the pendency of the appeal, unless such authorization and the incurring such debt, or the granting of such priority or lien, were stayed pending appeal.” The court pointed out that nothing comparable to the language of Section 364(e) covers payment made to pre-existing, unsecured creditors, whether or not the debtor calls them critical. Judges do not invent missing language. The court pointed out that the appeals involving the critical vendor issues do not question any distribution under the plan; to the contrary, the plan — which was confirmed — provides that adversary proceedings will be filed to recover the preferences that the critical vendors have received. It is the appellants that now wage a collateral attach on the plan of reorganization. Debtor argued that the court should recognize reliance interests — after the order, they continued selling goods and services to the debtor. Continued business relations may or may not be a form of reliance. The vendors have been paid in full for post-petition goods and services. If Kmart had become administratively insolvent and unable to compensate the vendors for post-petition transactions, then it might make sense to permit vendors to retain payments under the critical vendors order, or a least to the extend of the post-petition deficiency. Because Kmart emerged as an operating business, however, no such question arises, according to the court of appeals. The vendors have not established that any reliance interest — let alone any language in the code — blocks future attempts to recover preferential transfers on account of pre-petition debts. The court, after discussing several procedure issues, then arrived at the merits. The lower court stated that the debtor relied upon Section 105(a) of the bankruptcy code and quoted “doctrine of necessity” as the basis for the bankruptcy court’s authority to create “critical vendor” status. The court of appeals pointed out that Section 105(a) of the bankruptcy code allows the court to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of the code.” This, however, does not create discretion to set aside the code’s rules about priority and distribution; the power conferred by Section 105(a) is one to implement rather than override. The court went on to state that every circuit that has considered the question has held that this statute does not allow a bankruptcy judge to authorize full payment of any unsecured debt, unless all unsecured creditors in the class are paid in full. The court agreed with the view of Section 105: “The fact that a [bankruptcy] proceeding is equitable does not give the judge a free-floating discretion to redistribute rights in accordance with his personal views of justice and fairness, however enlightened those views may be.” The court similarly dismissed the concept of “doctrine of necessity” stating that a doctrine of necessity is just a fancy name for a power to depart from the code. Although courts, in the days before bankruptcy law was codified, wielded power to reorder priorities and pay particular creditors in the name of “necessity,” since the adoption of the Bankruptcy Act of 1898 and the Bankruptcy Code of 1978, no such doctrine exists. Such a doctrine of necessity may survive as glosses on ambiguous language but not as freestanding entitlements to trump the text. The ultimate issue as the court stated was whether the code contains any grant of authority for debtors to prefer some vendors to others. Many sections require equal treatment or specify the details of priority when assets are insufficient to satisfy all claims. Appellants attempted to rely upon 11 U.S.C. Sections 363(b), 364(b) and 503 as sources of authority for unequal treatment. Section 364(b) reads: “The court, after notice and a hearing, may authorize the trustee to obtain unsecured credit or to incur unsecured debt other than under subsection (a) of this section, allowable under Section 503(b)(1) of this title as an administrative expense.” While this authorizes the debtor to obtain credit has nothing to say about how the money will be disbursed or about priorities among creditors. Furthermore, Section 503, which deals with administrative expenses, likewise is irrelevant. Pre-filing debts are not administrative expenses; they are the antitheses of administrative expenses. The court pointed out that filing a petition for bankruptcy effectively creates two firms: the debts of the pre-filing entity may be written down so that the post-filing entity may reorganize and continue in business if it has a positive cash flow. Treating pre-filing debts as administrative claims against the post-filing entity would impair the ability of bankruptcy law to prevent old debts from sinking a viable firm. The next argument of the appellants was to cite Section 363(b)(1): “The trustee [or debtor in possession], after notice and a hearing, may use, sell, or lease, other than in the ordinary course of business, property of the estate.” The court dismissed this argument on behalf of the appellants and stated that while there is some possibility that this may be, nevertheless, because of the very unsoundness of the order granting critical vendor status, Section 363(b)(1) would not support payment of some pre-petition debts. The court pointed out that the foundation of a critical-vendors order is the belief that vendors not paid for prior deliveries will refuse to make new ones. Without merchandise to sell, a retailer such as the debtor (Kmart) would fold. If paying the critical vendors would enable a successful reorganization and make even the disfavored creditors better off, then all creditors favor payment whether or not they are designated as “critical.” This suggests a use of Section 363(b)(1) similar to the theory underlying a plan crammed down the throats of an impaired class of creditors. If the impaired class does at least as well as it would have under a Chapter 7, then it has no legitimate objection and cannot block the reorganization. For this premise to hold true, however, the court stated, it is necessary to show not only that the disfavored creditors would be as well of 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. If vendors will deliver against a promise of current payment, then reorganization can be achieved and all unsecured creditors will obtain their benefits, without preferring any of the unsecured creditors. The court went on to discuss other reasons why pre-petition vendors would continue to do business with the debtor without the designation of “critical vendor,” i.e. doing business under a letter of credit or requiring completing the business pursuant to a long term contract which the automatic stay prevents the vendor from walking away. The court went on to point out that none of these issues were explained to the court, nor was a testimony or alternatives presented to the court. In language that was critical of the bankruptcy judge and may be interpreted to be critical of many first day orders, the court of appeals for the 7th Circuit stated that the bankruptcy court did not explore the possibility of using any of the alternatives, such as letter of credit. Furthermore, the court did not find that any firm would have ceased doing business with Kmart if it had not paid for pre-petition deliveries, and the scant record would not have supported such a finding had one been made. The court did not find that discrimination amongst unsecured creditors was the only way to facilitate reorganization. Additionally, it did not find that the disfavored creditors were at least as well off as they would have been had the critical-vendors order not been entered. The court stated, “For all the millions of dollars at stake, this proceeding looked much like a Chapter 13 reorganization that produced In re Crawford.” Crawford classified his creditors in a way that enabled him to pay off the debts that would not be discharged, while stiffing the creditors whose debts were dischargeable. The court replied that in that event the classification is impossible. The court reiterated its position that even if Section 362(b)(1) 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 to the other creditors. The court went on to state that the record in this case does not show this necessary requirement. The court affirmed the decision of the district court reversing the critical vendor order; this issue is becoming more and more of interest to debtors and committees. Debtor’s counsel can no longer rely upon “first day orders” and must be prepared to prove almost in each and every case that vendors are essential and why, as well as establishing the need for such payment and that no other method of payment is available to the debtor. Obviously, as this court pointed out, there must also be a showing that the disfavored creditors would do as well under reorganization as they would under Chapter 7. Issues arising out of this decision include what is the status of post-petition payments made to a vendor in reliance upon the critical vendor order. Any hearing on the issue would be long and costly. What vendor would testify it would ship goods without payment if by responding in the negative could provide for payment? If the present trend continues, Congress may have to amend the code to allow for critical vendors.

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