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For years, Chapter 11 debtors have realized that you cannot operate in bankruptcy if your necessary vendors won’t continue to supply goods and services. (Some creditors simply “can’t take a joke” and refuse to do business in the face of outstanding pre-petition claims.) From this discrete problem grew a “doctrine of necessity” that, in turn, begat more and more creditors being deemed “critical” by debtors, until the exceptions finally became the rule. The Feb. 24 decision of the U.S. Court of Appeals for the 7th Circuit in In re Kmart Corp. has either curtailed this process or, at a minimum, “raised the bar” on proving necessity. Typically, “critical vendors motions” are filed on the first day of larger bankruptcy cases, requesting permission to pay in full certain pre-petition claims of creditors considered “necessary” to the restructuring. Thus, in Kmart, the debtor paid over $300 million in pre-petition claims to 2,330 “critical” vendors. The 7th Circuit affirmed the district court’s reversal of the critical vendor order, ruling that the bankruptcy court strayed too far from the code and its policy of equal treatment of all creditors. The court rejected the “doctrine of necessity” and several other rationales for preferential treatment of certain pre-petition creditors. (Importantly, the “doctrine of necessity” supports a wide variety of first-day orders sought by debtors, and is not limited to vendors.) NOT A DEATH KNELL Fortunately, the decision is not a death knell for all preferential payments to pre-petition creditors. The decision pivots not solely on exegesis of case law or statutory interpretation, but also on the facts of this case — in particular, the absence of any showing that the payments served the best interests of the debtors’ estates. The quotation marks that surround the word “critical” throughout the opinion express the court’s skepticism about the true necessity of the payments to Kmart’s restructuring. As discussed below, the court left open the possibility that §363(b)(1) could support post-petition preferential payments. As such, the immediate impact of Kmart should be to focus on the threshold for a factual showing of necessity to justify post-petition payments of pre-petition claims. As a preliminary issue, the court rejected the argument that it was too late to reverse the bankruptcy court’s order because of the suppliers’ detrimental reliance. Reasoning that nothing in the Bankruptcy Code forbids unwinding improper transactions, the court held that any reliance was not “detrimental” when suppliers were fully paid for the post-bankruptcy shipments. Additionally, the court dismissed any due process objections that vendors were not parties to the motion, reasoning that the debtors were the movant-appellees, even if the vendors benefited. Vendors also had a chance to participate through intervention in the appeal. Turning to the merits, the court flatly rejected reliance on the “doctrine of necessity” as a court-made doctrine originating in the railroad organization cases of the late 19th century. The court held: “Today the Bankruptcy Code of 1978 supplies the rules. . . . Answers to contemporary issues must be found within the Code (or legislative halls). Older doctrines may survive as glosses on ambiguous language enacted in 1978 or later, but not as freestanding entitlements to trump the text.” The court observed that “[t]he ‘doctrine of necessity’ is just a fancy name for a power to depart from the Code.” Practice note: This determination goes beyond the “critical vendor” motions and applies to a wide variety of first-day orders seeking to pay pre-petition claims under the old doctrine, e.g., customs duties, employee wages, and foreign vendors. Looking for support in the Bankruptcy Code, the court held that §105(a), which allows a court to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of” the code, “does not create discretion to set aside the Code’s rules about priority and distribution; the power conferred by §105(a) is one to implement rather than override. . . . [T]his 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.” Likewise, §364(b), which authorizes post-petition credit, and §503, which concerns administrative expenses, were rejected as irrelevant. The court’s statutory interpretation was guided by the code’s policy of equal treatment of creditors: “Many sections require equal treatment or specify the details of priority when assets are insufficient to satisfy all claims. E.g., 11 U.S.C. §§507, 1122(a), 1123(a)(4).” Importantly, this reasoning — together with the invalidation of the “doctrine of necessity” — could have consequences beyond those discussed in Kmart, reaching to a reorganized debtor’s need to “prefer” certain critical creditors as part of a restructuring. For example, courts have allowed debtors to separately classify, and so to preferentially treat, trade creditors in a Chapter 11 plan from other unsecured creditors in exchange for a commitment of credit to the reorganized debtor. See In re Lafayette Hotel Partnership (S.D.N.Y. 1998) (court allowed discriminatory plan treatment of unsecured creditors in favor of trade creditors in exchange for new credit support). In analyzing the Bankruptcy Code sections that did not support post-petition payments, the court left open the possibility that §363(b)(1), which allows a debtor to “use, sell, or lease, other than in the ordinary course of business, property of the estate,” could lend support. Notably, the court did not restrict an interpretation of “other than in the ordinary course” only to capital projects. The court observed that precedent requires equal treatment of creditors unless a statute, such as §363, provides otherwise. In Kmart, the court held that it was “prudent” to read §363(b)(1) to do the least damage to priorities established by the code and that the “order was unsound no matter how one reads §363(b)(1).” ATTENTION, KMART VENDORS It was in this context that the court analyzed the facts affecting Kmart. The debtors’ rationale for a critical-vendors motion was “that some suppliers may be unwilling to do business with a customer that is behind in payment, and, if it cannot obtain the merchandise that its own customers have come to expect, a firm such as Kmart may be unable to carry on, injuring all of its creditors.” Thus, as in cramdown of a plan, all creditors should theoretically support payment of critical vendors. “[I]f the impaired class does at least as well as it would have under a Chapter 7 liquidation, then it has no legitimate objection and cannot block the reorganization,” according to the 7th Circuit. In light of this rationale, the court found it significant that Kmart failed to demonstrate that “supposedly critical vendors would have ceased deliveries if old debts were left unpaid.” An example concerned the Fleming Cos., which each week sold $70 million to $100 million in goods to Kmart and received the largest pre-petition payment. However, Fleming was bound by long-term contracts with the debtor to ship. “No matter how much Fleming would have liked to dump Kmart, it had no right to do so,” wrote the court. As long as Kmart paid for post-petition deliveries, Fleming was legally prevented from walking away by the automatic stay. The court further observed that, as a practical matter, it was unlikely that Fleming would not have shipped if Kmart paid for new goods. “To abjure new profits because of old debts would be to commit the sunk-cost fallacy; well-managed businesses are unlikely to do this,” according to the court. The court did acknowledge, however, that “many suppliers fear the prospect of throwing good money after bad.” The court stated that it was problematic that the bankruptcy court did not explore other possibilities for assuring vendors, which “need not, however, entail payment for pre-petition transactions.” For example, Kmart could have paid cash on delivery or issued a letter of credit for the benefit of vendors under its $2 billion line of credit. ARE CRITICAL-VENDOR ORDERS DEAD? Although the pre-code “doctrine” supporting preferential payments to creditors may be in critical condition (at least in the 7th Circuit), the relief need not be considered dead. For starters, debtors must meet their burden of proving that the relief sought is warranted. According to the court, “[T]he debtor must prove, 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.” The decision disfavors blind reliance on pre-code “doctrines” in favor of a more sophisticated analysis to justify the cost of the proposed preferential treatment to the actual post-petition benefit to the estate. It also requires debtors to properly scrutinize the proposed beneficiaries of the relief sought. Recalcitrant creditors who are contractually obligated to ship (like Fleming) must do so or face violations of the automatic stay. This allows the debtor to focus the relief sought — and dollars expended — on those necessary creditors who cannot be compelled to perform. Adam C. Rogoff is a partner in the financial restructuring department of Cadwalader, Wickersham & Taft in New York, where he concentrates on complex transactional, litigation, and advisory work. He can be reached at [email protected]. Jessica Clarke, an associate in the department, assisted in the preparation of this article.

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