This article focuses on In re Payless Cashways Inc., 268 B.R. 543 (Bankr. W.D. Mo. 2001), and other cases in which courts have approved the debtor's payment of certain critical vendors' pre-petition unsecured claims, usually in exchange for an agreement to continue shipping goods on the same credit terms during the chapter 11 case. As a result, low-priority, pre-petition general unsecured claims can be converted to higher-priority administrative claims arising from post-petition credit sales to the debtor. But as demonstrated by In re CoServ L.L.C., 273 B.R. 487 (Bankr. N.D. Tex. 2002), not all courts will rubber-stamp a debtor's request for preferential treatment of vendors' pre-petition claims.

Necessity as a Justification for a Debtor's Payment of Critical Vendors' Pre-petition Claims

The courts have approved the debtor's payment of certain pre-petition unsecured claims during the bankruptcy based on the "doctrine of necessity" or the "necessity of payment rule." This rule was first enunciated by the U.S. Supreme Court in Miltenberger v. Logansport C. & S.W.R. Co., 106 U.S. 286 (1882), and has been followed by numerous courts. Since the enactment of the Bankruptcy Code, courts approving such payments have also relied on the bankruptcy court's equitable powers under §105(a), which allows a bankruptcy court to "...issue any order, process or judgment that is necessary or appropriate to carry out the provisions of this title." They have approved the debtor's payment of certain pre-petition unsecured claims when necessary for a successful reorganization, or to at least preserve the potential of a rehabilitation of the debtors' business or prevent a liquidation.

For example, certain courts have approved the payment of critical vendors' pre-petition unsecured claims¹ and unsecured pre-petition wage and benefit claims.² However, certain circuit courts of appeal have denied the payment of any pre-petition unsecured indebtedness prior to confirmation of a chapter 11 plan.³

The necessity doctrine became an exception to the general claims priority rules. Under these rules, claims are paid based on where they are situated on the claims priority ladder, and claims in the same class of creditors are entitled to the same treatment. At the top of the ladder are secured and lien creditors entitled to payment of their claims from the proceeds of their collateral and a general unsecured claim for any deficiency.⁴ Next in line are the administrative priority claims of creditors that provide goods and services to the debtor or trustee, or to whom the debtor or trustee becomes indebted, during the bankruptcy case.⁵ Creditors holding lower-level priority claims, such as certain employee wage, salary, benefit, tax and other claims, are entitled to payment in a designated order of priority from the debtor's unencumbered assets, after the full payment of all administrative priority claims and before any payment or other distribution can be made to the debtor's creditors holding pre-petition general unsecured claims.⁶ Pre-petition unsecured creditors occupy the lowest creditor rung of the priority ladder and are not entitled to receive any distribution from the debtor until the higher-priority creditors are paid in full.

Payless Cashways Payment of Critical Vendors' Pre-petition Unsecured Claims

The debtor, Payless Cashways Inc., operated 117 stores and was in the business of selling lumber and wood products and other building materials to both contractors and individuals. When Payless filed its chapter 11 (during the peak summer season), it lacked sufficient wood and ancillary products to satisfy customer needs. Payless also lacked the cash and trade credit to purchase additional product. As a result, Payless lost significant sales.

Payless decided to seek court approval of the payment of the pre-petition unsecured claims of certain of its critical lumber vendors. Critical lumber vendors receiving payment of their pre-petition claims had to agree to extend unsecured credit to Payless, based on credit terms at least as favorable as the standard industry terms, for up to one year after confirmation of a chapter 11 plan. Participating vendors would be granted an administrative priority claim for the amount of any unpaid post-petition credit extended to Payless under §§503(b) and 507(a) of the Bankruptcy Code.

The court approved the payment of the pre-petition unsecured claims of Payless's critical lumber vendors based on §364(b) of the Bankruptcy Code rather than §105(a). Section 364(b) gives the court broad authority to approve credit arrangements out of the ordinary course of business and grant the credit provider an allowed administrative expense claim. The court recognized that Payless could not induce suppliers to extend credit based on the bare promise of an administrative claim that is subject to the prior security interest of Payless's pre-petition lender. Payless had to offer something else to obtain trade credit: the payment of critical vendors' pre-petition claims.

The court relied on the following: (1) the creditors' committee approved the arrangement; (2) the critical lumber vendors had refused to extend credit and ship the product in the quantities and within the time frames required by Payless unless their pre-petition claims were paid; (3) the amount paid to the critical vendors was just two percent of Payless's pre-petition debt; (4) the continued delivery of goods by Payless's critical lumber vendors was critical to the survival of Payless's business; and (5) the transactions between Payless and its critical vendors were at arms' length.

The court also held that critical vendors receiving payment of their pre-petition unsecured claims cannot be compelled to disgorge the payments as preferences in the event of a conversion of the debtor's chapter 11 case to a chapter 7 liquidation. Section 549 of the Bankruptcy Code prohibits a debtor's payment of pre-petition claims unless the payment is otherwise authorized under the Bankruptcy Code or by an order of the bankruptcy court. Critical vendors should not be forced to disgorge payments of their pre-petition claims received pursuant to a court order, particularly where they were induced to continue doing business with the debtor on credit terms in reliance upon such court-approved payments.

The court in In re Wehrenberg Inc., 260 B.R. 468 (Bankr. E.D. Mo. 2001), also approved the debtor's payment of the pre-petition unsecured claims of several vendors. The vendors had threatened to stop delivery of films to the debtor (an operator of a chain of movie theaters) unless their pre-petition claims were paid. The court considered them critical vendors and approved the payment of their pre-petition claims as necessary for the debtor's continued operation.

The Kmart Critical Vendor Orders

The bankruptcy court in Kmart Corp.'s chapter 11 case recently approved orders authorizing Kmart's payment of all or a portion of the pre-petition claims of certain critical vendors.⁷ One of them, Fleming Companies Inc., a food distribution company, had a pre-petition claim of approximately $76 million against Kmart. Fleming is Kmart's largest supplier, providing substantially all of the food and consumable products in Kmart's stores as well as the infrastructure for Kmart's food and consumables businesses. A second critical vendor is Handleman Co., Kmart's sole music vendor, which provides the infrastructure for Kmart's music business and had a pre-petition unsecured claim of approximately $64 million. Kmart's egg and dairy vendors are also critical vendors since their goods attract shoppers to Kmart's stores. They are also a critical source of supply who might not survive if their pre-petition claims were not paid. Newspapers, printers, paper suppliers and ad production businesses that are necessary for Kmart's weekly newspaper circular program are also critical vendors.

Kmart also obtained court approval for the payment of the pre-petition claims of certain liquor vendors. Kmart argued that these vendors are precluded by state law from extending credit beyond a fixed number of days and would have otherwise been precluded from continuing to do business with Kmart.

Kmart's payment of critical vendors' pre-petition claims is conditioned on their agreement to continue selling goods and/or providing services to Kmart on the same trade terms they had offered to Kmart on a historical basis prior to the chapter 11 filing ("customary trade terms"), or on such other terms that are at least as favorable to Kmart. Kmart may require participating critical vendors to sign an agreement. The agreement includes, among other terms, confirmation of the amount of the critical vendors' pre-petition claims, obligating critical vendors to continue to extend credit to Kmart based on customary trade terms for two years, and binding all of the terms of the court order approving Kmart's payment of their pre-petition claims. Critical vendors also must agree to forego exercising any rights and remedies (such as reclamation or stoppage of delivery claims) with respect to, and/or enforcing any liens that secure payment of, their pre-petition claims. Finally, participating vendors that fail to comply with the bankruptcy court order authorizing the payment of their pre-petition claims and/or their agreements with Kmart may be forced to disgorge the payment or have it offset against unpaid invoices from their post-petition shipments of goods.

The CoServ L.L.C. Decision

The court in In re CoServ L.L.C. made clear that it would not rubber-stamp a debtor's request to pay the pre-petition claims of certain favored vendors during the chapter 11 and would carefully scrutinize such requests. A debtor seeking the pre-chapter 11 plan payment of a vendor's pre-petition claim had to satisfy the following three requirements:

• The payment is indispensable to the debtor's business. A sole supplier of a given product would satisfy this element of the test;
• Non-payment of the claim risks probable harm or eliminates an economic advantage disproportionate to the amount of the claim; and
• There is no practical or legal alternative to payment of the claim.

The court stated that a critical vendor cannot use its leverage to extort the payment of its pre-petition claim, particularly where the debtor and vendor had entered into a contract pre-petition and the debtor was continuing to perform under the contract post-petition. Such "economic blackmail" may violate the automatic stay under §362(a) of the Bankruptcy Code. See In re Structurlite Plastics Corp., 86 B.R. 922, 932 (Bankr. S.D. Ohio 1988).

The court applied this three-point test to approve the payment of the pre-petition claims of two vendors and deny the payment of the pre-petition claims of five vendors. A vendor that continues to do business with a debtor if the vendor received a pre-payment, deposit or other assurance of payment would not qualify. A vendor also would not qualify where the debtor could obtain the same goods elsewhere.

Conclusion

More bankruptcy courts have invoked the necessity doctrine to approve the payment of certain critical vendors' and other creditors' pre-petition unsecured claims during their customer's chapter 11 case. However, a court may not necessarily rubber-stamp a debtor's request and may instead require proof that the payment is indispensable to the success of a debtor's case.

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Footnotes

¹ In re Just For Feet Inc., 242 B.R. 821 (D. Del. 1999); In re Wehrenberg, 260 B.R. 468 (Bankr. E.D. Mo. 2001). Return to article

² See In re Equalnet Communications Corp., 258 B.R. 368 (Bankr. S.D. Tex. 2000); In re UNR Industries Inc., 143 B.R. 506, 519-20 (Bankr. N.D. Ill. 1992), rev'd. on their grounds; UNR Industries Inc. v. Bloomington Factory Workers, 173 B.R. 149, 158-59 (Bankr. N.D. Ill. 1994); In re Gulf Air Inc., 112 B.R. 152 (Bankr. W.D. La. 1989); In re Ionosphere Clubs Inc., 98 B.R. 174 (Bankr. S.D.N.Y. 1989). Return to article

³ See Official Committee of Equity Sec. Holders v. Mabey, 832 F 2d. 299 (4th Cir. 1987), cert. denied, Mabey v. Official Committee of Equity Sec. Holders of M.H. Robins Co. Inc., 485 U.S. 962, 108 S. Ct. 1228, 99 L. Ed. 2d 428 (1988) (creation of emergency treatment fund for Dalkon Shield claimants prior to confirmation of plan violated Bankruptcy Code and could not be justified as an exercise of court's equitable powers under §105(a); In re FCX Inc., 60 B.R. 405 (E.D.N.C. 1986) (court denied payment of pre-petition payroll taxes, expenses and other unsecured claims in the absence of grounds for subordinating other unsecured claims, such as inequitable conduct by remaining creditors). See, also, In the Matter of Oxford Management Inc., 4 F. 3d 1329, 1334 (5th Cir. 1993); In the Matter of B&W Enterprises Inc., 713 F. 2d 534, 535-37 (9th Cir. 1983). Return to article

⁴ 11 U.S.C. §506(a). Return to article

⁵ 11 U.S.C. §507(a). Return to article

⁶ 11 U.S.C. §507(a)(2)-(9). Return to article

⁷ In re Kmart Corp. et al., Chapter 11, Case No. 02-B-02474 (SPS) (Bankr. N.D. Ill. Jan. 25, 2002) and (Bankr. N.D. Ill. Feb. 13, 2002). Both orders are subject to pending appeals. Return to article