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Quite often, unpaid vendors/suppliers threaten to refuse to continue to provide services and supplies to a Chapter 11 debtor during its Chapter 11 case until and unless their prepetition claims are immediately and fully paid in cash. As a result, management of Chapter 11 entities are faced with the prospect of serious damage to the value of the company unless payment in full is made to these essential vendors/suppliers and employees. Many courts under an equitable doctrine, known as the “doctrine of necessity,” which developed under case law predating the Bankruptcy Code of 1978 have allowed Chapter 11 debtors to pay certain critical vendors/suppliers provided the debtor establishes an evidentiary record establishing a business justification for such payment. [FOOTNOTE 1] In a recent decision in the U.S. District Court for the District of Illinois [FOOTNOTE 2] the bankruptcy court in the Kmart Corp.Chapter 11 case was reversed for having authorized the Chapter 11 debtor to pay in full certain critical vendors/suppliers. This decision has caused quite a stir in the bankruptcy profession because the court ruled that the bankruptcy court did not have per se authority to authorize such payments. As a result, even if a debtor could establish that its business would be seriously harmed if certain critical vendors/suppliers terminated services without payment of the prepetition debt, the bankruptcy court would be powerless to grant such a request. BACKGROUND In some cases, Chapter 11 debtors will seek to avoid the need to request court approval to pay prepetition critical vendor/supplier claims by prepaying such vendors/suppliers an amount sufficient to make sure that no amounts are outstanding to the critical vendor/supplier as at the date of the Chapter 11 filing. As a practical matter, because of cash flow and lending restraints a debtor may not be able to assure that all of its significant vendors/suppliers upon entering into Chapter 11 are fully current. Consequently, many Chapter 11 debtors have no choice but to request authorization from the bankruptcy court to pay in full prepetition unsecured claims of certain critical vendors/suppliers. Bankruptcy courts have articulated under a “doctrine of necessity” those circumstances in which payments to prepetition vendors/suppliers will be authorized prior to confirmation of a Chapter 11 plan. Typically, the only creditors who are specifically allowed under the Bankruptcy Code to be paid during a Chapter 11 case and prior to the Chapter 11 plan confirmation are those administrative creditors who provide postpetition services to the debtors and those creditors who are entitled to adequate protection payments. [FOOTNOTE 3] Nowhere in the Bankruptcy Code is there a specific provision that allows the payment in full of certain prepetition unsecured claims to the exclusion of other similarly situated prepetition unsecured claims outside the context of a Chapter 11 plan. In fact, one may argue that payment in full of prepetition critical vendors/suppliers unfairly discriminates against the remaining unsecured creditors of the debtor’s Chapter 11 estate who are likely to realize a fraction, if any, of the face amount of their allowed claims under the debtor’s Chapter 11 plan [FOOTNOTE 4] or, perhaps, in an eventual Chapter 7 liquidation. PRACTICE UNDER THE BANKRUPTCY ACT The modern practice of granting orders on the first day to pay prepetition debts under the Bankruptcy Code originates from railroad reorganization cases under the Bankruptcy Act by way of the “Six Months Rule” and the “Necessity of Payment Rule.” [FOOTNOTE 5] The Six Months Rule authorized receivers assigned to manage railroad reorganizations to pay certain prepetition expenses incurred immediately prior to the petition for reorganization, essentially creating a priority status for those expenses that were necessary to keep the railroad operational. [FOOTNOTE 6] The Necessity of Payment Rule also justified the payment of certain prepetition creditors to secure the continued delivery of supplies or services considered essential to the reorganization effort. The Necessity of Payment Rule was first addressed by the U.S. Supreme Court in Miltenberger v. Logansport Railway. [FOOTNOTE 7] In Miltenberger,interline railroads threatened to stop furnishing supplies unless the railroad receiver immediately paid pre-receivership claims. [FOOTNOTE 8] The Supreme Court affirmed the circuit court order directing the railroad to pay the pre-receivership claims prior to reorganization. The Court found that such payments are “necessary … where a stoppage of [indispensable] business relations would be a probable result.” [FOOTNOTE 9] In Dudley v. Mealey,the 2nd U.S. Circuit Court of Appeals extended the doctrine for payment of prepetition claims beyond railroad reorganization cases. [FOOTNOTE 10] Dudley v. Mealeyhas been cited in later cases as authority for extending the “doctrine of necessity” to non-railroad cases. [FOOTNOTE 11] PRACTICE UNDER BANKRUPTCY CODE OF 1978 The “doctrine of necessity” functions in a Chapter 11 reorganization as a mechanism by which the bankruptcy court can exercise its equitable power under � 105 of the Bankruptcy Code to allow payment of critical prepetition claims not explicitly authorized by the Bankruptcy Code. Section 105(a) of Title 11 of the U.S. Code (the Bankruptcy Code) empowers a court to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.” 11 USC � 105(a). A bankruptcy court’s use of its equitable powers to “authorize the payment of prepetition debt when such payment is needed to facilitate the rehabilitation of the debtor is not a novel concept.” [FOOTNOTE 12] A substantial number of courts have held that “[u]nder Section 105, a court can permit pre-plan payment of a prepetition obligation when essential to the continued operation of the debtor.” [FOOTNOTE 13] Courts typically require that the debtor establish a business justification for payments of prepetition claims at an evidentiary hearing. At the hearing, the debtor must convince the court that absent such payments, prior to the debtor’s Chapter 11 plan, the business would suffer certain and serious harm that would impair the debtor’s chances for a successful reorganization. The court in In re Boston & Me. Corp.recognized the existence of a judicial power to authorize trustees to pay claims for goods and services that are indispensably necessary to the debtors’ continued operation. [FOOTNOTE 14] The doctrine is frequently invoked early in a reorganization, particularly in connection with those Chapter 11 sections that relate to payment of prepetition claims. The court in In re Structurelite Plastics Corp.,indicated its accord with “the principle that a bankruptcy court may exercise its equity powers under section 105(a) to authorize payment of prepetition claims where such payment is necessary to ‘permit the greatest likelihood of survival of the debtor and payment of creditors in full or at least proportionately.’” [FOOTNOTE 15] The court stated that “a per se rule proscribing the payment of prepetition indebtedness may well be too inflexible to permit the effectuation of the rehabilitative purposes of the Code.” [FOOTNOTE 16] The rationale for the doctrine of necessity rule is consistent with the paramount goal of Chapter 11: “facilitating the continued operation and rehabilitation of the debtor. …” [FOOTNOTE 17] One commentator has noted that “[p]repetition debts of the same class are often treated differently in reorganization cases when a court is confronted with special circumstances. In many instances, particularly in the early stages of the case, a court may authorize the payment of prepetition debts in order to preserve the potential for rehabilitation. This is particularly true where the operation would otherwise terminate with disastrous effects.” [FOOTNOTE 18] Despite the long history behind the “doctrine of necessity,” from the times of the railroad reorganizations to its current use in large Chapter 11 cases to ensure that the debtor will be able to obtain the materials and retain the employees necessary to give the company a legitimate chance of reorganization, certain appellate courts have been pushing back on the use of � 105 alone to authorize postpetition payments of prepetition obligations. [FOOTNOTE 19] For example, the 9th Circuit in B&W Enterprises Inc.was the first to conclude that Bankruptcy Code � 105(a) did not justify the payment of prepetition obligations absent compelling reasons holding that it was “unwise to tamper with the statutory priority scheme devised by Congress.” [FOOTNOTE 20] The 3rd U.S. Circuit Court of Appeals in Southern Railway Co.followed in holding that � 105(a) does not authorize bankruptcy courts to elevate the claims of certain unsecured creditors absent specific statutory authority. [FOOTNOTE 21] Unfortunately, these cases ignore the fact that the exercise of the bankruptcy courts’ powers under � 105 is done specifically with other code provisions in mind. As will be discussed below, Bankruptcy Code � 363, which addresses use of the debtor’s property, is the provision typically invoked by the bankruptcy courts in conjunction with � 105 under the “doctrine of necessity.” The Kmartdecision unfortunately joins these decisions, holding the bankruptcy court does not have the power or authority under the code to authorize the payment in full of prepetition claims prior to confirmation of the debtors plan or reorganization. ‘KMART’ As part of its first-day motions, Kmart sought authority to pay prepetition obligations to certain “critical vendors” and certain “foreign vendors.” Kmart contended that these payments were necessary to maintain relationships essential to its continued operation and reorganization, and it invoked the “doctrine of necessity” and � 105(a) for the bankruptcy court’s authority to permit these payments. [FOOTNOTE 22] The same day, the bankruptcy court held a hearing and heard evidence on these motions. Capital Factors (a factoring agent for a number of Kmart’s apparel suppliers and a holder of a general unsecured claim against the bankruptcy estate for approximately $20 million) objected to both motions. [FOOTNOTE 23] After hearing the testimony of Kmart in support of these motions, the bankruptcy court granted both motions. On Feb. 1 and 8, 2002, Kmart filed motions seeking authority to pay issuers of prepetition letters of credit and liquid vendors. On Feb. 13, the bankruptcy court held a hearing on these motions, heard evidence and granted both motions over the objections of Capital Factors. The bankruptcy court held that there was a “good business justification” for granting the motions. [FOOTNOTE 24] Capital Factors appealed the bankruptcy court’s decision to grant the motions arguing that the bankruptcy court did not have the authority in exercise of its power to enter such orders pursuant to � 105. [FOOTNOTE 25] The district court reversed the bankruptcy court orders approving payment of critical vendors, foreign vendors, issuers of prepetition letters of credit and liquid vendors. The court held that such payments cannot be authorized under � 105 and the doctrine of necessity because doing so contradicts the express statutory priority scheme under the Bankruptcy Code. [FOOTNOTE 26] The district court recognized that � 105′s power is limited because “it allows [bankruptcy] courts to use their equitable powers only as necessary to enforce the provisions of the Code, not to add to the Code as they see fit.” [FOOTNOTE 27] The court did not address whether payment of prepetition debts prior to confirmation of a Chapter 11 plan may be justified by applying � 105 used in conjunction with another statutory provision of the Bankruptcy Code, such as Bankruptcy Code � 363. In an attempt to justify an order which allowed for the payment of prepetition claims to the issuers of certain letters of credit, JP Morgan Chase submitted a supplemental brief which argued that the court “properly allowed those payments [pursuant to � 361 of the Bankruptcy Code] on the basis that such payments constituted adequate protection for the issuers’ secured reimbursement claims under the letters of credit.” [FOOTNOTE 28] The court noted that in authorizing the payments to the issuers of the letters of credit, the bankruptcy court did not rely on � 361. [FOOTNOTE 29] Neither Kmart nor the issuers raised the adequate protection issue under 361 to support the letters of credit motion. ANALYSIS The Kmartdistrict court correctly pointed out that � 105, standing alone, should not be used to reorder the priority scheme. However, many of these essential first day payments are justified when � 105 is read in conjunction with other provisions of the Bankruptcy Code, [FOOTNOTE 30] such as � 363, which allow for the use of property outside of the ordinary course of business. Bankruptcy Code subsection 363(b) states that “the trustee, after notice and a hearing, may use, sell, or lease, other than in the ordinary course of business, property of the estate.” [FOOTNOTE 31] Subsection 363(c)(1) permits a debtor who is authorized to operate a business to enter into transactions and to use property of the estate in the ordinary course of business, without notice or a hearing. A bankruptcy court is empowered pursuant to � 363 of the Bankruptcy Code to authorize a debtor to use funds in the bankruptcy court’s discretion outside the ordinary course of business. [FOOTNOTE 32] Thus, � 363(b) read in conjunction with 105(a) gives the court broad authority and flexibility in tailoring its orders to meet a wide variety of circumstances, including the authorization for payment of certain prepetition claims. [FOOTNOTE 33] In In re Eastern Air Lines,the court approved Eastern’s motion to pay certain prepetition wage, salary, medical benefit and business expense claims of its active employees. [FOOTNOTE 34] The International Association of Machinists and Aerospace Workers (IAM) moved for an order authorizing and directing Eastern to pay similar benefits to union-represented striking employees for services rendered before the petition was filed. [FOOTNOTE 35] IAM argued that all prepetition wage and salary claims of active employees and IAM-represented employees then on strike were subsection 507(a)(3) priority claims, which must be treated equally. [FOOTNOTE 36] The bankruptcy court dismissed IAM’s argument by applying subsection 363(b) in conjunction with 105(a) and by finding that the debtor “did articulate some business justification, other than mere appeasement of major creditors, for using, selling or lease property outside of the ordinary course of business pursuant to section 363.” [FOOTNOTE 37] The business purposes put forth under 105(a) and 363(b) were to “preserve and protect the Debtors business and ultimately reorganize, retain its current employees and maintain positive employee morale.” [FOOTNOTE 38] In In re Chateaugay Corp.,the debtors moved to make certain retiree benefit payments that were stopped when the debtor’s petition for bankruptcy was filed. The court allowed the prepetition payments under the theory that the payment was permitted pursuant to � 105(a) in conjunction with 363(b), which permits the use of property other than in the ordinary course of business. [FOOTNOTE 39] Upon appeal of the order, the district court did not take issue with the prepetition payments. [FOOTNOTE 40] Once again, the use of � 105 in conjunction with specific statutory provisions of the Bankruptcy Code provided the court with a clear statutory basis from which to grant the debtors’ motion. CONCLUSION The issue that should be addressed in these cases is not whether the bankruptcy court has the power to approve payments of critical vendor/supplier prepetition claims, but whether a sufficient evidentiary record has been established to demonstrate a business justification for such payments. While no fixed formula can be used in each and every case, practitioners should be prepared to submit evidence through a qualified financial officer of the debtor which establishes the acute need for the critical vendor/supplier payments and the harm that will accrue to the debtor’s business if such payments are not approved early on in the debtor’s Chapter 11 case. The Kmartdecision, while misguided in its application of the law, is likely to remind practitioners and courts alike of the need for careful scrutiny of critical vendor/supplier payment motions. What remains to be seen is whether other courts are likely to follow in the footsteps of Kmartand other similar decisions by holding they simply do not have the statutory basis to grant the relief requested even in the face of well founded business justifications. John J. Rapisardi is a member of Weil, Gotshal & Manges ( www.weil.com ). Scott J. Greenberg, an associate of the firm, assisted in the preparation of this article. If you are interested in submitting an article to law.com, please click here for our submission guidelines. ::::FOOTNOTES:::: FN 1The Necessity of Payment Rule was first addressed by the U.S. Supreme Court in Miltenberger v. Logansport Railway, 106 US 286, 312 (1882). In Miltenberger, interline railroads threatened to stop furnishing supplies unless the railroad receiver immediately paid pre-receivership claims. The Supreme Court affirmed the circuit court order directing the railroad to pay the pre-receivership claims prior to reorganization. The Court found that such payments are “necessary … where a stoppage of [indispensable] business relations would be a probable result.” FN 2 Capital Factors, Inc. v. Kmart Corp., 2003 WL 1868753, 2 (N.D.Ill. 2003). FN 3 See11 USC �� 503(b), 507(a), and 361. FN 4 See Capital Factors, Inc. v. Kmart Corp., 2003 WL 1868753, 2 (N.D.Ill. 2003) (holding that the bankruptcy code does not carve out priority or administrative expense status for prepetition general unsecured claims based on the critical or integral status of a creditor); See also Southern Railway Co. v. Johnson Bronze Co., 758 F.2d 138, 141 (3d Cir. 1985) (holding that section 105(a) does not authorize bankruptcy courts to elevate the claims of certain unsecured creditors absent specific statutory authority). FN 5Barsalou, Patricia L. & Mosner, Zack, “Preferential First Day Orders: Same Question, Different Look,” 22 Am. Bankr. Inst. J. 8 (February 2003). FN 6 Id. FN 7 Miltenberger v. Logansport Railway, 106 US 286 (1882). FN 8 Id. FN 9 Id. FN Dudley v. Mealey, 147 F2d 268 (2d Cir. 1945), cert. denied 325 US 873 (1945). FN 11 See, e.g., In re Financial News Network, Inc., 134 B.R. 732, 735 (Bankr. S.D.N.Y. 1991). FN 12 Id. FN 13 In re NVR L.P., et al., 147 B.R. 126, 127 (Bankr. E.D. Va. 1992) (citing Ionosphere Clubs, 98 B.R. at 177). FN 14 In re Boston & Me. Corp., 634 F2d 1359, 1382 (1st Cir. 1980). FN 15 In re Structurelite Plastics Corp., 86 B.R. 922, 931 (Bankr. S.D. Ohio 1988). FN 16 Id.at 932. FN 17 In re Ionosphere Clubs, Inc., 98 B.R. 174, 175 (Bankr. S.D.N.Y. 1989). FN 18R. Ordin, “Finality of Order of Bankruptcy Court,” 54 AM. Bankr. L.J. 173, 177 (1980). FN 19 See B&W Enterprises Inc, 713 F2d 534, 536 (9th Cir. 1983); see also Southern Railway Co. v. Johnson Bronze Co., 758 F2d 138, 141 (3d Cir. 1985). FN 20 See B&W Enterprises Inc., 713 F2d 534, 536 (9th Cir. 1983). FN 21 See Southern Railway Co. v. Johnson Bronze Co., 758 F2d 138, 141 (3d Cir. 1985). FN 22 Capital Factors, Inc. v. Kmart Corp., 2003 WL 1868753, 2 (N.D.Ill. 2003). FN 23 Id. FN 24 Id. FN 25 Id. FN 26 Id. FN 27 Id. FN 28 Id. FN 29 Id. FN 30The other code provisions include 11 USC �� 549, 1107 and 1108. FN 3111 USC �363(b)(1) (1982). FN 32Eisenberg, Russell A. & Gecker, Frances F., “The Doctrine of Necessity and Its Parameters,” 73 Marq. L. Rev. 1, 39 (1989). FN 33 Id.. (acknowledging that other code provisions such as ��549, 1107, 1108 may also be used in conjunction with �105 under the “doctrine of necessity”). FN 34 In re Eastern Airlines, Inc., 98 B.R. 174, 175 (Bankr. S.D.N.Y.1989). FN 35Eisenberg and Gecker, at 30. FN 36 Id. FN 37 Id.at 31. FN 38 Id. FN 39 In re Chateaugay Corp., 80 B.R. 279, 287 (SDNY 1987). FN 40Eisenberg & Gecker, at 28.

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