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Bankruptcy courts increasingly have allowed Chapter 11 debtors to fully pay the pre-petition debts they owe to suppliers of essential goods or services as a part of their first-day orders, orders the court issues at the outset of a bankruptcy case. The rationale for these critical-vendor payments is that they ultimately benefit all unsecured creditors. If critical vendors refuse to do business with the Chapter 11 debtor without first receiving full payment for their pre-petition debts, permitting the debtor to pay the critical vendors before the bankruptcy court confirms the company’s bankruptcy plan assures a continuing source of goods and services needed to keep its business running. The reorganized debtor then will be able to pay disfavored creditors more under its Chapter 11 plan than those disfavored creditors would have received had the business been liquidated because the debtor could not obtain essential goods or services. But critical-vendor payments face formidable objections. First, it is unclear whether the U.S. Bankruptcy Code authorizes the bankruptcy court to allow payment of pre-petition unsecured debts, except under a duly confirmed reorganization plan. Second, critical-vendor payments appear to offend the well-established bankruptcy principle that creditors with the same nonbankruptcy rights must receive equivalent treatment: Critical vendors get paid in full, whereas disfavored unsecured creditors typically get paid only a fraction of their claims under the reorganization plan. Kmart’s Chapter 11 case, In Re: Kmart Corp., et al., filed in the U.S. Bankruptcy Court for the Northern District of Illinois on Jan. 22, 2002, shows these considerations at work. On the day Kmart filed its petition, the bankruptcy court granted Kmart’s request for permission immediately to pay in full the pre-petition claim of any vendor that Kmart unilaterally deemed critical, provided the vendor agreed to continue supplying goods to Kmart on customary trade terms. Kmart then paid the pre-petition debts of 2,330 suppliers — a total of about $300 million, according to the opinion. Under the reorganization plan, Kmart eventually paid its remaining 45,000 unsecured creditors only about 10 percent of their claims, mostly in the form of stock in the reorganized company. The district court later reversed the bankruptcy court’s order, and the 7th U.S. Circuit Court of Appeals affirmed that reversal. In November 2004, the U.S. Supreme Court denied certiorari. The 7th Circuit held that the statutory authority usually cited by proponents of critical-vendor payments does not empower the bankruptcy court to allow the debtor to make them, unless all creditors of the same class are fully paid. Section 105(a) of the Bankruptcy Code permits a bankruptcy court to “issue any order, process or judgment that is necessary or appropriate to carry out the provisions” of the Bankruptcy Code. Since the objective of a Chapter 11 proceeding is reorganizing the debtor’s business, a debtor seeking permission to make critical-vendor payments could argue that �105(a) authorizes the bankruptcy court to allow them, since they are “necessary or appropriate” to achieving that end. But the 7th Circuit adopted a narrower view of �105(a), holding that the power it confers “is one to implement rather than override” and may not be used to reorder the Bankruptcy Code’s priority-and-distribution scheme. Critical-vendor payments reorder those priorities by treating critical vendors better than those not deemed critical. But in a surprising bit of dictum, the 7th Circuit suggested that �363(b)(1) might authorize the entry of critical-vendor orders. Under that section, “[t]he 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.” Since paying a pre-petition claim to preserve an essential source of supply is a use of property outside the ordinary course of administering the bankruptcy estate, the court speculated that this provision might authorize making critical-vendor payments that reorder the usual creditor priorities. But the court stopped short of deciding whether �363(b)(1) does authorize such payments, because it found the bankruptcy court’s order was unwarranted in any event. If critical-vendor payments are ever justifiable, the court said, the debtor must show that 1. critical vendors would cease delivering goods to the debtor without immediate full payment of their pre-petition claims, and 2. the disfavored noncritical vendors would be at least as well off in a Chapter 11 reorganization as they would be in a Chapter 7 liquidation. Kmart simply failed to establish a factual record necessary to meet these conditions. UNSETTLED ISSUE The Kmart decision left the status of critical-vendor payments up in the air in the 7th Circuit, but the matter is no better settled here in Texas. Bankruptcy lawyers and judges often read the 5th U.S. Circuit Court of Appeals’ 1993 opinion in In the Matter of Oxford Management Inc. as forbidding critical-vendor payments. That reading is understandable, because the 5th Circuit held that the bankruptcy court improperly invoked �105(a) when it ordered the debtor to pay in full certain unsecured pre-petition claims prior to plan confirmation. But Oxford Management is not a critical-vendor case. The debtor was a commercial leasing broker, and the creditors were associate brokers who sought their shares of commissions earned pre-petition. Neither the debtor nor anyone else argued that, without payment of their commissions, the associate brokers would refuse to provide services essential to the debtor’s business survival. Indeed, the debtor resisted paying the brokers’ claims. Thus, the 5th Circuit did not confront those circumstances that purportedly make critical-vendor payments defensible. Bankruptcy judges in Texas have found exceptions to the general prohibition established in Oxford Management. The leading case is 2002′s In Re: CoServ LLC, in which Judge Dennis Michael Lynn of the U.S. Bankruptcy Court for the Northern District of Texas approved critical-vendor payments on conditions similar to those suggested by Kmart. But in In Re: Mirant Corp., decided the following year, Lynn went even further. Concerned that requiring Mirant to obtain the court’s prior approval of critical-vendor payments under the CoServ standards might interrupt the debtor’s provision of electric power, he authorized Mirant to pay those unsecured creditors it reasonably believed qualified under those standards. Moreover, Lynn even allowed the debtor to pay creditors it believed did not qualify if they demanded such payments as a condition of continuing to do business with the debtor, although he imposed certain conditions designed to reduce the risk that creditors would exploit that authorization to obtain payments improperly. Bankruptcy judges in the Northern and Southern Districts of Texas also have allowed debtors to pay pre-petition wage claims before confirmation of the Chapter 11 plan. These decisions recognize that such payments do not undermine the equality-of-treatment principle the way ordinary critical-vendor payments do. To encourage employees not to quit when their employer files for bankruptcy and to protect especially vulnerable unpaid employees, the Bankruptcy Code accords a third priority for up to $4,925 in wages earned within 90 days of bankruptcy and requires the plan to pay those claims in full. In some cases, paying wage claims before plan confirmation arguably promotes the purposes underlying the code’s priority scheme, provided that all priority wage claims are paid equally, payments are limited to those amounts entitled to priority and higher priority claims also are fully paid. The status of critical-vendor payments in Texas remains uncertain. But the lesson of Kmart is that, if such payments are permissible at all, they should be the rare exception rather than the rule. The debtor should have to affirmatively show that paying its supplier’s pre-petition debt is the only way it can obtain essential goods or services. This means that such payments are unwarranted where the vendor contractually is obligated to do business with the debtor or where the debtor readily can obtain the goods or services elsewhere. They also are inappropriate if requiring the debtor to pre-pay, post a deposit, pay cash on delivery, secure a letter of credit, or provide some other guarantee would adequately protect the vendor’s right to payment for post-petition goods or services. Indeed, it is difficult to imagine circumstances in which a vendor reasonably would refuse to accept such guarantees of the debtor’s post-petition performance, unless it inappropriately was trying to collect a greater percentage of its pre-petition debt than unsecured creditors generally would receive. Moreover, since the justification for critical-vendor payments is that they will benefit all unsecured creditors, the court should require the debtor to demonstrate that disfavored creditors would receive more under any proposed reorganization plan than they would receive if the debtor were liquidated. Proponents of critical-vendor payments will say that requiring a Chapter 11 debtor to make such a comparative showing in the early days of a reorganization proceeding is unrealistic, but what Kmart suggests is that the debtor may be obliged to make just such an extraordinary showing to justify such an extraordinary procedure. John J. Worley is a professor at South Texas College of Law where he teaches courses in commercial law and bankruptcy. Before joining the South Texas faculty, he served as law clerk to 5th U.S. Circuit Court of Appeals Judge Charles Clark and practiced commercial and banking law with Kilpatrick Stockton in Atlanta. Worley is a graduate of the University of Georgia School of Law.

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