Hold on to Those Payments Critical Vendors: Capital Factors v. Kmart

Hold on to Those Payments Critical Vendors: Capital Factors v. Kmart

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Editor's Note:For another perspective on Capital Factors v. Kmart, see the Last in Line column.

Many of the first-day motions that a chapter 11 debtor files are designed to smooth the transition from a company operating outside of bankruptcy to one operating under the Bankruptcy Code.

To minimize disruption to operations, as an exception to the general rule that a debtor cannot pay pre-petition claims, the debtor typically seeks court authority to pay a portion or all of the pre-petition claims of certain classes of pre-petition creditors under the doctrine of necessity, which has been applied by bankruptcy courts to approve payments to critical vendors (critical vendor motions), employees, lien creditors and customer programs, among others. For critical vendors, the rationale is that the debtor relies on certain vendors for critical products and services, and unless the debtor is permitted to pay its pre-petition debts to these essential vendors, they likely will stop supplying the debtor, and the debtor's chances of successfully reorganizing will be impaired.

The Capital Factors v. Kmart Corp.1 decision overturned the bankruptcy court's approval of certain first-day motions including the motion seeking authority to pay the pre-petition claims of critical trade vendors and foreign vendors. The reasoning underlying the decision raises serious concerns about the continued viability of the doctrine of necessity. The Kmart decision is currently on appeal, but if upheld by the Seventh Circuit, it could have significant and wide-ranging implications for debtors and creditors alike.

Historical Basis

The Six Months Rule. The authority for preferentially paying pre-petition claims of certain creditors arises in part from the Six Months Rule, an equitable rule of priority followed in railroad reorganization cases.2 Under this rule, railroad receivers were entitled to pay the unpaid claims of operations creditors arising in the six months preceding the reorganization before paying mortgagees and secured creditors, giving these claims a priority status. Operating creditors were paid on a priority basis because they supplied services and products to the railroads that contributed to the railroads' revenue generation. Under this rationale, they should not have to stand behind secured creditors and mortgagees when a railroad reorganized.3

The Necessity of Payment Rule. In addition to the Six Months Rule, the Necessity of Payment Rule is another railroad reorganization doctrine that has provided a foundation for the contemporary practice of paying critical vendors. Under the necessity-of-payment doctrine, a railroad receiver was protected in making payments to certain pre-petition creditors whose goods and services were essential to continuing rail service.4

Expansion of the Necessity of Payment Rule. The Necessity of Payment Rule was justified, in part, because the continued operation of rail lines was essential to protect the public interest. Preferring certain creditors at the expense of others was acceptable because the public depended on continued rail operations. Over time, courts began to employ the Necessity of Payment Rule in non-railroad cases involving other businesses important to the public interest. Eventually, however, the focus on protecting the public interest gave way to a focus on protecting the interests of creditors generally—and the Necessity of Payment Rule worked its way into mainstream business bankruptcy cases.5

Contemporary Authority

The Doctrine of Necessity. The doctrine of necessity is the contemporary incarnation of the Necessity of Payment Rule, and is frequently considered to have been incorporated into the Bankruptcy Code by 11 U.S.C. §105(a). A debtor may seek to utilize the doctrine of necessity by demonstrating that paying some pre-petition debts is critical to the debtor's survival and successful reorganization.6 The doctrine of necessity also has provided a basis for (1) paying pre-petition wages, (2) maintaining customer programs, (3) paying certain lien creditors, (4) maintaining insurance programs and (5) paying for post-petition deliveries of goods ordered pre-petition by vendors.

Arguments debtors often make when relying on the doctrine of necessity to authorize critical vendor payments for pre-petition claims include: (1) the vendor represents the only source of essential goods or services, (2) the vendor provides essential goods or services at a significantly reduced price, or (3) the vendor will be unable to survive non-payment of pre-petition claims, and will thereafter cease to supply the debtor.

A recent Northern District of Texas decision has adopted a restrictive interpretation of the doctrine of necessity in the critical-vendor context.7 Eschewing a traditional analysis, the court set forth three conditions that the debtor must prove in order for a creditor to be considered a critical vendor: (1) it must be critical that the debtor deal with the claimant; (2) unless it deals with the claimant, the debtor risks the probability of harm, or alternatively, loss of economic advantage to the estate or the debtor's going-concern value, which is disproportionate to the amount of the claimant's pre-petition claim; and (3) there is no practical or legal alternative by which the debtor can deal with the claimant other than by payment of the claim. This decision appears more focused on the last element, suggesting that debtors have several mechanisms at their disposal, besides paying a claimant's pre-petition debt, to ensure that a pre-petition creditor continues to deal with the debtor post-petition.8

Section 105(a) of the Code. Typically, debtors cite to §105(a) in conjunction with the common-law doctrine of necessity.9 Section 105(a) provides in part that a "court may issue any order, process or judgment that is necessary or appropriate to carry out the provisions of this title." Several courts have expressly limited the application of §105(a) for paying pre-petition debts.10

Some courts have relied on either §105(a), the doctrine of necessity or both to permit debtor payments of certain critical vendors' pre-petition unsecured claims in exchange for an agreement to continue shipping goods on the same credit terms during the chapter 11 cases.11 These agreements essentially result in the conversion of lower priority pre-petition general unsecured claims into higher priority administrative claims.

Practical Considerations. As the successful reorganization of a company is one goal underlying the Code, it may make sense to look at the bankruptcy court's powers under §105(a) from a cost-benefit analysis in the context of critical vendor payments. If paying a critical vendor $10,000 at the beginning of a case for pre-petition debts may net the estate $20,000 over the course of the case, permitting critical vendor payments likely benefits all parties concerned and increases the likelihood of a successful reorganization. Moreover, there may be situations in which not paying a critical vendor will result in a loss to the estate far exceeding the cost of bringing that vendor current (i.e., a replacement provider charges twice as much for the same essential good or service, or a foreign vendor seizes an asset notwithstanding the stay).

Components of a Typical Critical Vendor Motion

Payment Cap. Many critical-vendor motions specify an aggregate maximum amount up to which the debtor can pay pre-petition claims to critical vendors. Usually this cap does not constitute the total pre-petition amount owed to all critical vendors. A debtor usually seeks authority to pay only the amount necessary for it to continue in business. The debtor should reserve the right to seek later court authority to increase this amount if the cap proves inadequate.

Conditions to Payment. Many critical-vendor motions ask the court to enter an order, and occasionally to approve a form agreement to be entered into by the debtor and a critical vendor, which conditions payment upon the vendor abiding by the following guidelines: (1) removal of all liens, (2) agreement not to initiate new liens and (3) agreement that it will not require a lump-sum payment upon confirmation of a reorganization plan on account of any administrative expense priority claim it might assert.

Identification.12 Many critical-vendor motions contain a section identifying the categories or names of specific critical vendors the debtor seeks authority to pay. Some critical vendor motions do not identify any critical vendors or amounts to be paid, in which case the critical-vendor motion will set forth criteria that the debtors will apply to assess whether a vendor is critical. Some of the considerations that debtors list in the motion are whether (1) the goods or services provided can be replaced, (2) the failure to pay a critical vendor will require the debtor to incur higher costs for goods or services post-petition, (3) the failure to pay a critical vendor will cause the debtor to lose sales or future revenues and (4) the failure to pay a critical vendor will cause a delay in supply of critical goods and services.

Practical Pointers

From the Debtor Side. There are numerous approaches to critical-vendor motions; what will work best for a debtor's business will ultimately depend on the circumstances surrounding the filing. Different approaches include (1) employing a specific list of vendors, with specific payment amounts; (2) using no list, but identifying criteria the debtor will employ to make determinations about who is a critical vendor; (3) identifying some critical vendors, but allowing flexibility to use criteria to determine other critical vendors; (4) capping (or not capping) the aggregate payment amount; (5) requiring vendors to enter into new agreements with customary (or better) terms; and (6) making partial payments to critical vendors, rather than paying pre-petition amounts in full.

Debtors should quickly identify critical vendors, especially where their continued provision of credit is needed to keep all or a substantial part of the business intact. This requires substantial pre-petition planning and a careful examination of the rationale put forward by key executives of the debtor, who often will contend that scores of vendors are critical to the continuation of the business. By getting the court's approval early in the case, business and payments can continue uninterrupted.

Debtors should check that the motion authorizes, but does not direct, the debtor to make critical-vendor payments so that the debtor retains the flexibility to decline to treat particular suppliers as critical vendors.

In cases involving multinational businesses, it may make sense to file a separate motion seeking to pay the claims of all or some foreign vendors critical to the continuation of the business. The underlying justification can be even stronger than for domestic critical vendors—the court is often without power to enforce the automatic stay in the foreign location. However, the court's lack of jurisdiction over foreign vendors may also counsel against making payments for pre-petition claims because there is no practical way to enforce an order or agreement to continue to provide goods and services on favorable terms.

From the Vendor Side. To the extent possible, a vendor should utilize its leverage to force the debtor specifically to name the vendor in its critical vendor motion. This avoids the situation in which the debtors' businesspeople mislead the vendors' businesspeople by promising critical vendor payments but never designating the vendor as critical (or paying the vendor).

Where possible, vendors should use an agreement to provide post-petition goods and services on customary terms as an opportunity to extract a promise from the debtor that it will not seek to assert preference claims (or §549 claims) against the vendor. This §547 and 549 waiver should be drafted to remain effective even if the chapter 11 case converts to a chapter 7 case or in the event of a liquidating chapter 11 case. When signing a new agreement for supply and credit terms, a vendor should make it clear that the agreement is a post-petition contract and avoid provisions that purport to allow the debtor to "reject" the new agreement.

Capital Factors v. Kmart Corp.

A recent decision13 of the Northern District of Illinois reversed the bankruptcy court's orders approving payments of pre-petition claims to critical vendors, foreign vendors, liquor vendors and issuers of letters of credit on the basis that the bankruptcy court was without statutory or equitable authority to allow such payments. The court ruled that neither §105(a) nor the equitable doctrine of necessity could permit the bankruptcy court to "ignore the Bankruptcy Code's statutory scheme of priority in favor of 'equity.'"14

The court found that even though pre-plan payment of certain pre-petition claims may allow "the debtor to minimize disruptions in doing business, and thus may further reorganization," such payments are not authorized by the Code. "Congress has not elected to codify the doctrine of necessity or otherwise permit pre-plan payment of pre-petition unsecured claims."15 Notwithstanding the practical difficulty of doing so, Kmart may need to recapture all of the pre-petition payments it made based on the orders appealed.

If this decision is upheld on appeal, it may change the way a debtor approaches bankruptcy. Venue choices will be influenced because payments to critical vendors will no longer be an option in the Seventh Circuit. Also, there will be an underlying concern that courts in other circuits may follow the Seventh Circuit's example. This could lead to an erosion in the confidence with which many debtors now approach first-day motions—that simply by saying numerous vendors are critical, debtors can receive broad authority to make payments outside the Code's priority scheme. It may mean that vendors that formerly would have been treated as critical must stand in line just like every other unsecured creditor. The decision may rein in the trend of permitting substantial payments by the estate on the first day and before the committee has been formed. The end result may be that debtors follow the literal language of the Code, which may not be such a bad thing after all.


1 Case No. 02 C 1264, (N.D. Ill. April 8, 2003), Memorandum Opinion (J. Grady). Return to article

2 Congress codified the Six Months Rule in railroad cases only. See 11 U.S.C. §1171(b). Return to article

3 See Cousins, Steven N., et al., "The Doctrine of Necessity—Everything is Critical!," ABI Annual Spring Meeting 2002, available on Westlaw at 041802 ABI-CLE 149 (discussing the historical basis of the Six Months Rule). See, also, White, Bruce H. and Medford, William L., "The Doctrine of Necessity and Critical Trade Vendors: The Impracticality of Maintaining Post-petition Business Relations in Mega-cases," ABI Journal, September 2002 at 24, available at Westlaw at 21-SEP Am. Bankr. Inst. J. 24 (2002). Return to article

4 Cousins, Steven N., "The Doctine of Necessity" at 4, and Barsalou, Patricia L., and Mosner, Zack, "Preferential First-day Orders: Same Question, Different Look," 22-Feb Am. Bankr. Inst. J., 8 (2003) (discussing Necessity of Payment Rule and Six Months Rule). Return to article

5 See Cousins, Steven N., "The Doctrine of Necessity" at 5 (discussing the expansion of the Necessity of Payment Rule). Return to article

6 See, e.g., In re Just for Feet Inc., 242 B.R. 821 (D. Del. 1999); In re Federated Dept. Stores Inc., 121 B.R. 332 (Bankr. S.D. Ohio 1990); In re Boston & Maine Corp., 634 F.2d 1359 (1st Cir. 1980). Return to article

7 See In re Coserve L.L.C., 273 B.R. 487 (Bankr. N.D. Tex. 2002). Return to article

8 Id. at 498-99. Among these "alternatives" are a deposit, c.o.d., letters of credit, consignment arrangements and the ability to sue a claimant for violating the automatic stay if a claimant is attempting to coerce payment of pre-petition debt by linking such payment to the provisions of credit post-petition. Id. at 499. Return to article

9 See, e.g., In re Ionosphere Clubs Inc., 98 B.R. 174 (Bankr. S.D.N.Y. 1989). Return to article

10 The Fifth Circuit has held that the post-petition payments of pre-petition debts should be allowed only in a limited number of situations, even under §105. See In the Matter of Oxford Management Inc., 4 F.3d 1329 (5th Cir. 1993). The Fourth Circuit reversed a decision of the district court establishing an emergency treatment fund for claimants after chapter 11 proceedings had begun, but prior to plan confirmation. The district court had relied on §105 and the "dire circumstances of the case." See Official Committee of Equity Security Holders v. Mabey, 832 F.2d 299, 301 (4th Cir. 1987). The Fourth Circuit held that the district court's order violated "the clear policy of [c]hapter 11 reorganization by allowing piecemeal, pre-confirmation payments to certain unsecured creditors." Id. at 302. In dicta, the Sixth Circuit has stated that the bankruptcy court could not authorize a pre-confirmation debtor to make pre-petition debt payments, even if the payments were needed to prevent a strike that could potentially shut-down the debtor's business. See In re Crowe & Associates Inc., 713 F.2d 211 (6th Cir. 1983). Return to article

11 See, e.g., In re Payless Cashways Inc., 268 B.R. 543 (Bankr. W.D. Mo. 2001); In re K-Mart Corp., et al., chapter 11, Case No. 02-B-02474 (SDS) (Bankr. N.D. Ill. Jan. 25, 2002). For a discussion of these and other contemporary cases, see "Critical Vendors: Elevating the Lower Priority Unsecured Claims of Pre-petition Trade Creditors," Nathan, Bruce S., ABI Journal, June 2002 at 14, 32-33, available on Westlaw at 21-JUN Am. Bankr. Inst. J. 14 (2002). Return to article

12 Some critical-vendor motions describe the implementation of a detailed system to track payments made to critical vendors. Return to article

13 Supra at note 1. Return to article

14 Id. at 7-8. Return to article

15 Id. at 8. Return to article

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Sunday, June 1, 2003