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Several months ago, in Capital Factors Inc. v. Kmart Corp., the U.S. District Court for the Northern District of Illinois addressed whether a bankruptcy court could authorize a debtor-in-possession to pay “critical vendors” for pre-petition debts. The issue in Capital Factors arose when the bankruptcy court issued an order allowing Kmart to pay the pre-petition claims of vendors deemed by Kmart to be critical vendors. The bankruptcy court’s decision was based on its interpretation of � 105(a) of the bankruptcy code, which allows a bankruptcy court to “issue any order, process or judgment that is necessary or appropriate to carry out the provisions” of the code. Specifically, the bankruptcy court held that this equitable power could be drawn upon to authorize the payment of claims to vendors that are deemed to be “essential” to the debtor’s ongoing operation and ability to reorganize, commonly known as the equitable “doctrine of necessity.” Bankruptcy courts, including those within the 3rd U.S. Circuit Court of Appeals, have long applied the doctrine of necessity. However, when the Northern District of Illinois addressed the issue in Capital Factors, it found that such an application of � 105 would have the effect of allowing bankruptcy courts to expand upon the statutory provisions of the bankruptcy code and alter the statutory scheme established by the code for the payment of claims. Because this would impermissibly expand the bankruptcy courts’ authority, the district court held that authorization of such payments was inappropriate, and any payments made would have to be returned to the debtor’s estate. The district court’s opinion was discussed earlier in this column, where we observed that, at least in the Northern District of Illinois, bankruptcy courts were limited in their authority to allow a debtor to pay critical vendors (i.e., those that a debtor deems critical). At the time, the impact of this decision was noteworthy because it impacted the ability of Chapter 11 debtors to appease vendors deemed critical to the debtors’ ongoing operations. Recently, the 7th U.S. Circuit Court of Appeals considered the issue on appeal. Although the district court’s ruling was affirmed, the appellate court’s discussion of the issue provides debtors some additional guidance in preparing a motion seeking to authorize payments to critical vendors. In Re Kmart Corp., the 7th Circuit agreed with the district court that the bankruptcy court had erred in permitting payments to certain of Kmart’s vendors. In doing so, the court of appeals concluded that the bankruptcy court’s decision was unsound because it had not required the debtor to prove that these vendors were so critical to Kmart’s reorganization that paying them was necessary in order to insure that Kmart would continue to receive goods and an act that would positively impact Kmart’s operations and consequently benefit all other unsecured creditors. However, perhaps the more important passages of the Kmart opinion lie within dicta, which shed some light as to whether, how, when and on what basis a debtor-in-possession might be permitted to pay critical vendors for debts that would otherwise be governed by the bankruptcy code’s priority scheme. NO DETRIMENTAL RELIANCE Before beginning its analysis of the doctrine of necessity and the propriety of payment to critical vendors, the court considered the appellants’ argument that because the payments had been made 14 months before the district court rendered its decision, the funds could not be returned. The vendors asserted that they had relied — to their detriment — on the validity of the bankruptcy court’s order in continuing to sell goods and services to Kmart. The court easily rejected this argument, noting that while continuing a business relationship “may or may not be a form of reliance,” it did not constitute detrimental reliance in the case, because the vendors had been, or would be, fully paid for their post-petition sales to Kmart. Moreover, the court noted that no section of the bankruptcy code precluded Kmart’s recovery of pre-petition debts from the vendors. THE DOCTRINE OF NECESSITY The court of appeals then considered the primary basis of the district court’s decision — that � 105(a) of the bankruptcy code does not give a bankruptcy court the power to override other bankruptcy code provisions aimed at the equal treatment of unsecured creditors. Noting that prior to the codification of bankruptcy laws, courts had “wielded power to reorder priorities and pay particular creditors in the name of ‘necessity,’” the court stated that the code’s explicit statutory requirement — that similarly situated creditors be treated equally — may not be ignored or overridden. Observing that “[o]lder doctrines may survive as glosses on ambiguous language enacted in 1978 or later, but not as freestanding entitlements to trump the text” of the code, the court found no authority under � 105 to support the payment of critical vendors. On the contrary, the court of appeals noted that the power conferred on bankruptcy courts through � 105 is the power to implement other provisions of the bankruptcy code — not to override them. OTHER STATUTORY SOURCES In addition to affirming the primary legal basis for the district court’s decision, the court considered the appellants’ arguments that other statutory sections of the bankruptcy code support the payment of critical vendors. Specifically, the appellants argued that such payments could be authorized under � 364(b), which authorizes a debtor to obtain post-petition credit; Section 503, which permits the payment of administrative expenses for transactions that benefit the estate; or � 363(b), which allows a debtor to use, sell or lease its property outside of the ordinary course of its business. The appellate court quickly rejected the suggestion that payments to critical vendors could be made under either � 364(b) or � 503. The court first reasoned that � 364(b) did not apply because that section merely allows a debtor to obtain credit during the post-petition period; it does not address the debtor’s disbursement of funds or the priority of payments. In an equally short analysis, the court rejected the authorization of critical vendor payments under � 503, noting the distinction between debts incurred by the pre-filing entity and those incurred by the estate during the post-petition period. Stating that “[p]re-filing debts are … the antithesis of administrative expenses,” the court dismissed the argument that sales to critical vendors for pre-petition sales could be considered administrative expenses of a debtor’s estate. Finally, the court of appeals considered whether a debtor could make these payments as payments to critical vendors pursuant to � 363(b)(1), characterizing a use of funds outside of the ordinary course of a debtor’s business. While it was careful to state that it “need not decide whether Section 363(b)(1) could support payment of some pre-petition debts, because this order was unsound no matter how one reads Section 363(b)(1),” the court went on to discuss the rationale for granting a critical vendor motion under � 363(b)(1). Beginning by noting that “the foundation of a critical-vendors order is the belief that vendors not paid for prior deliveries will refuse to make new ones,” the court reasoned that if making payments to these vendors would provide for a successful reorganization, such payments would make “even the disfavored creditors better off.” It then observed that such a use of funds outside of the ordinary course of a debtor’s business was analogous to cramming a reorganization plan “down the throats” of impaired creditors, noting that “if the impaired class does at least as well as it would have under a Chapter 7 liquidation, then it has no legitimate objection.” Thus, the court suggested that if a vendor has the right to stop deliveries and has indicated that it will do so and provides goods or services without which the debtor could not successfully reorganize, the payment of pre-petition debts to critical vendors might be an appropriate use of funds under � 363(b)(1). In addition to a careful evidentiary analysis, the court suggested that a bankruptcy court should consider whether there are any other options to provide security for critical vendors refusing to engage in post-petition sales to a debtor. For example, the court suggested that in Kmart’s case, a portion of a line of credit that the debtor secured upon entering bankruptcy could have been used to establish a standby letter of credit upon which the bankruptcy judge could authorize unpaid vendors to draw. This solution, the court noted, would have provided vendors certainty of payment without changing the terms of their agreements with the debtors. IMPLICATIONS OF ‘KMART’ Ultimately, the appellate court did not foreclose the possibility that a debtor make pre-petition payments to its critical vendors. Rather, the court appears to have clarified the burden of proof that must be met by a debtor seeking to make such payments. If only in dicta, Kmart appears to establish a clear and significant evidentiary burden for such an argument — a debtor must provide a sufficient amount of evidence that a critical vendor will stop making deliveries if not paid for pre-petition deliveries and that other unsecured vendors would ultimately benefit from this preferential treatment of the critical vendor. It is interesting to compare the requirements in the court’s dicta with the long-standing doctrine of necessity. While the doctrine of necessity allows that payments to a critical vendor be considered “essential” to the debtor’s survival, the test under Kmart seems to flesh out the meaning of “essential” — whether the vendor has truly and rightfully refused payment, and whether this particular vendor is truly crucial to a successful reorganization. In short, the equitable doctrine rejected by the court and the statutory doctrines promoted by the court (in dicta) appear to merge. A reorganizing debtor seeking the approval of pre-petition payments to critical vendors would be prudent to present evidence that a vendor has refused or will refuse delivery of goods unless pre-petition debts are paid, and that an uninterrupted supply of these particular goods is essential to the debtor’s successful reorganization (and therefore ultimately beneficial to other unsecured creditors). It appears that the court of appeals did not wish to eliminate the possibility that critical vendors be paid. Rather, it wished to clarify and narrow the scope of critical vendor payments by raising the evidentiary bar in order to protect other creditors. If you are interested in submitting an article to law.com, please click here for our submission guidelines.

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