Several years ago, this column addressed the then-growing tendency of bankruptcy courts to enter "first-day orders" allowing debtors to make post-petition payments on account of pre-petition unsecured employee wage claims over and above the priority limit established in the Bankruptcy Code, citing the authority of §105(a) and/or the "doctrine of necessity."² We noted then that state and federal agencies holding priority tax claims were unhappy with this trend, which subordinates priority claims to general unsecured claims—a practice that without question violates the statutory priority scheme enacted by Congress. In addition to absolute priority issues, the rapidity with which these orders are entered—often within the first few days of the case, well before state and federal agencies get notice of the bankruptcy filing, much less of a hearing—creates due process concerns that may call the validity of such orders into question.³

In the past few years, first-day orders have become routine, and state and federal agencies have been given little reason to hope the courts might limit debtors' ability to pay select pre-petition claims prior to confirmation. These days, in addition to employee wage claims, numerous other pre-petition, non-priority, unsecured claims are routinely paid under the authority of §105(a) and the doctrine of necessity. Recent columns in this publication have focused extensively on the "critical vendor" motions that are standard practice in today's larger cases,⁴ but all manner of unsecured claims are being paid under such orders, often after a hastily scheduled hearing at which the majority of creditors have no opportunity to appear.⁵

As is often the case in the practice of law, especially in the bankruptcy context, this now-routine practice is at odds with the black-letter law as interpreted by numerous circuit courts of appeal. The perceived "disconnect" between the bankruptcy courts and the circuit courts, which many bankruptcy practitioners attribute to the failure of the circuit judges to understand the practical implications of their decisions as they affect bankruptcy cases, may be attributable to the simple fact that the law does not allow what many bankruptcy courts have been doing.⁶

The practice of elevating certain "essential" or "critical" unsecured claims to priority status was originated in railroad reorganization cases under the Bankruptcy Act through the "Six Months Rule" and/or the "Necessity of Payment Rule." The Six Months Rule authorized receivers assigned to manage railroad reorganizations to pay certain pre-petition 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. Similarly, the Necessity of Payment Rule⁷—now more commonly called the "doctrine of necessity"—justified the payment of certain pre-petition creditors to secure the continued delivery of supplies or services considered essential to the reorganization effort. Both rules were applicable only in railroad reorganization cases, the success of which was considered vital to the public interest.

When Congress retained the Six Months Rule in the language of the Code, it also retained the limitation to railroad cases.⁸ There is some doubt as to whether the Necessity of Payment Rule survived the enactment of the Code, but even if it did, it too had traditionally been applied only in railroad reorganizations.⁹ Despite these specific statutory and historical limitations, many bankruptcy courts continue to extend one or both rules in non-railroad circumstances. Most, but not all, of the courts that have done so have relied on the equitable power provided in §105(a) of the Bankruptcy Code as authority.¹⁰

Not surprisingly, decisions at the circuit level have rejected the extension of these rules to non-railroad circumstances as well as bankruptcy court reliance on §105(a) for authority.¹¹ The Ninth Circuit was the first to conclude that neither rule was applicable and observe that absent compelling reasons, it is "unwise to tamper with the statutory priority scheme devised by Congress."¹² About the same time, the Sixth Circuit stated in dicta that a bankruptcy court could not permit a debtor to make pre-petition debt payments prior to confirmation, even to avoid a strike that would "shut down the debtor's operations."¹³

The Third Circuit weighed in a couple of years later, ruling that §105(a)—which does not create any substantive rights not otherwise available under applicable law—did not authorize bankruptcy courts to elevate the claims of certain unsecured creditors above others absent specific statutory authority.¹⁴ Similarly, the Fourth Circuit held that the equitable power conferred on the bankruptcy courts in §105 did not constitute a license to disregard the clear language and meaning of the Code, which it determined did not authorize the payment of unsecured claims prior to the confirmation of a plan of reorganization.¹⁵ The Fifth Circuit has also rejected an expansive reading of §105(a), holding that the exercise of equity power under §105 is limited by the statutory language of the Code and finding error where a bankruptcy court elevated certain pre-petition claims to priority status and deviated from the applicable statutory priority scheme.¹⁶

The circuit response to this issue leaves no question as to the state of the law: The Code specifically authorizes payment of pre-petition general unsecured claims only under a confirmed plan of reorganization. Yet, the practice of preferentially paying certain pre-petition unsecured claims continues, while priority creditors—including state and federal agencies—often await the confirmation of a plan of reorganization. Not all bankruptcy courts indulge in the wholesale preferential payment of pre-petition claims prior to confirmation. Recently, several bankruptcy courts in the Southern and Northern Districts of Texas have acknowledged the prohibition of payment of pre-petition claims prior to the confirmation of a plan, and have articulated narrowly tailored exceptions to facilitate payment of a limited class of claims under §105(a).¹⁷ Some claims are still being paid, but it appears that an additional level of scrutiny is being applied, at least in these courts.

As a few bankruptcy courts take a more exacting view of first-day motions in general, some have issued standing orders concerning the contents and variety of first-day motions that will be considered, and some have written local rules addressing the same issues.¹⁸ Whether these courts have taken their cue from the April 2, 1998, letter from Judge Peter J. Walsh to Delaware bankruptcy counsel regarding the content and effect of the orders he was expected to sign or whether they have been motivated by due process considerations, personal discomfort with the size and scope of orders to which they are expected to attach their names, or some other factor, it should be no surprise that courts may be hesitant to grant sweeping, substantive relief only a few days into a case at a time when many creditors have not been notified that the case is pending. As Judge Leif M. Clark noted in his Dicta column of April 2000 on first-day orders, the age and seniority of the bankruptcy bench is shifting. Perhaps some additional scrutiny will be applied as newer judges—who have themselves obtained first-day relief as practitioners—realize the nature and scope of the relief they are now expected to routinely grant.

The conclusion to our earlier column suggested that the best way to bring Congress's attention to the alleged need to have a doctrine of necessity or Six Months' Rule apply in non-railroad reorganization cases was for bankruptcy judges to enforce the Code as written and allow the drastic results that are always predicted to occur. If and when major corporate reorganizations are impacted because the Bankruptcy Code is enforced, the pressure on Congress to change the Code will increase dramatically. The routine entry of preferential orders releases that pressure and allows debtors, courts and certain well-positioned creditors (who usually get notice in time for first-day hearings) to act as though the Code has already been amended, while other parties, including priority tax creditors (who usually do not get timely notice), are relegated to the existing Code. This result, which may appear to be preferable in the short term, actually undermines the integrity of the bankruptcy system by enabling suppliers, employees and other general unsecured creditors with powerful positions to negotiate outside the rules to avoid the limitations of the Code. Even debtors arguably suffer as a result, because the practice of sanctioning preferential orders eviscerates the statutory protection built into the Code to guard against the coercive tactics used to secure such orders. Not only is this not what Congress intended when it enacted the Code, it is not in the best interests of the debtor, the creditor body, or the bankruptcy system.

Footnotes

¹ The views expressed herein are those of the authors and not necessarily those of their employers or of any clients or client agencies they may represent. Return to article

² See, e.g., Michigan Bureau of Workers' Disability Compensation v. Chateaugay Corp. (In re Chateaugay Corp.), 80 B.R. 279 (S.D.N.Y. 1987); 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). At about the same time, the bankruptcy court in In re Revco D.S. Inc., 91 B.R. 777, 780 (Bankr. N.D. Ohio 1988), actually rejected a request to pay the debtor's pre-petition tax debt to the state of Ohio, despite the fact that the claim would have been entitled to priority under the Code, because the Code did not authorize the payment of such claims prior to confirmation. Return to article

³ Governmental units are entitled to procedural due process. In re Duarte, 146 B.R. 958, 963, n.8 (Bankr. W.D. Tex. 1992) (citing United States v. Cardinal Mine Supply Inc., 916 F.2d 1087 (6th Cir. 1990) (analysis of constitutional and procedural due process in context of bankruptcy notice)). See In re Automation Solutions Int'l. LLC, 274 B.R. 527 (Bankr. N.D. Cal. 2002) (calling into question validity of provisions in order approving sale of assets purporting to affect governmental units who received no notice as violative of due process); In re U.S. Metalsource Corp., 163 B.R. 260 (Bankr. W.D. Pa. 1993) (highlighting damage caused by procedural shortcuts on first-day orders and improbability of "unringing the bell" once an order is entered). Return to article

⁴ See, e.g., White, Bruce and Medford, William, "The Doctrine of Necessity and Critical Trade Vendors: The Impracticality of Maintaining Post-petition Business Relations in Mega-cases," Practice & Procedure, 21 ABI Journal (September 2002), and Nathan, Bruce, "Critical Vendors: Elevating the Low-priority Unsecured Claims of Pre-petition Trade Creditors," Last in Line, 21 ABI Journal (June 2002). Even in Delaware, it was not always thus. See In re Columbia Gas System Inc., 171 B.R. 189 (Bankr. D. Del. 1994) (criticizing efforts to pay pre-petition creditors in advance of plan confirmation). Return to article

⁵ Indeed, many debtors' counsel routinely file motions to pay pre-petition taxes as first-day motions, although many such motions deal only with trust fund taxes or other taxes entitled to priority. Return to article

⁶ As an example, consider the reaction to the Third Circuit's September 2002 decision in Official Comm. of Unsecured Creditors v. Chinery et al. (In re Cybergenics), 304 F.3d 316 (3d Cir. 2002), which was vacated on Nov. 18, 2002, and has been set for rehearing en banc this month. In Cybergenics, the Third Circuit held that a creditors' committee lacked derivative capacity to bring suit under §544 to recover a fraudulent transfer. In doing so, the Third Circuit acknowledged that granting committees derivative capacity to sue was a longstanding, well-established practice; nevertheless, the court determined that the law, particularly a recent decision of the U.S. Supreme Court, mandated a rejection of the practice. While it remains to be seen what the Third Circuit will do after its en banc review, Cybergenics is illustrative of the circumstances that give rise to the "disconnect" thought to exist between the bankruptcy and circuit courts of appeal. Return to article

⁷ See B & W Enterprises Inc., 713 F.2d 534, 536-37 (9th Cir. 1983) (citing Boston and Maine Corp., 634 F.2d 1359, 1366 (1st Cir. 1980), cert. denied, 450 U.S. 982 (1981)). For an extensive discussion of this and other preferential orders, see Tabb, "Emergency Preferential Orders in Bankruptcy Reorganizations," 65 American Bankr. L.J. 75, 92 (Winter 1990). Return to article

⁸ The Six Months Rule is codified at §1171(b) of the Code and is limited in application to railroad reorganization cases pursuant to §103(g). B & W Enterprises Inc., 713 F.2d at 536. In enacting the rule, Congress specifically rejected the few cases that had extended the rule to non-railroad cases. See Tabb, supra at 93. Return to article

⁹ B & W Enterprises Inc., 713 F.2d at 537. Return to article

¹⁰ See, e.g., Just For Feet Inc., 242 B.R. 821, 824-25 (Bankr. D. Del. 1999) (same); In re Gulf Air Inc., 112 B.R. 152 (Bankr. W.D. La. 1989) (same). See, also, In re Payless Cashways Inc., 268 B.R. 543 (Bankr. W.D. Mo. 2001) (relying on §364(b) as authority to allow payment of pre-petition claims of trade creditor who extended additional credit to debtor post-petition); In re Isis Foods Inc., 37 B.R. 334, 336 n.3 (W.D. Mo. 1984) (relying on §549 to permit payment of pre-petition claims on theory that subsequently-appointed trustee could recover transfers); In re Ionosphere Clubs Inc., 98 B.R. 174, 176 (Bankr. S.D.N.Y. 1989) (relying on §§363(b) and 1107). Return to article

¹¹ The circuits rejecting the use of equitable authority to adjust congressionally mandated priorities are on the right track. See In re CoServ L.L.C., 273 B.R. at 495-96 (citing United States v. Noland, 517 U.S. 535, 116 S.Ct. 1524, 134 L.Ed.2d 748 (1996) and United States v. Reorganized CF&I Fabricators, 518 U.S. 213, 116 S.Ct. 2106, 135 L.Ed.2d 506 (1996): "While preferring "critical vendors" may not equate to subordination of a tax claim or penalty, it has the smell of a similar inappropriate adjustment of congressionally established priorities—and is therefore at odds with the rationale of Nolan and CF&I Fabricators."). Return to article

¹² B & W Enterprises Inc., 713 F.2d at 537. The debtor in the case was a trucking company; in declining to extend the rule to a transportation concern, the court re-emphasized the restriction of the rule to railroad cases. Return to article

¹³ See Crowe & Associates Inc. v. Bricklayers & Masons Union Local No. 2 (In re Crowe & Associates Inc.), 713 F.2d 211, 216 (6th Cir. 1983). The Sixth Circuit affirmed a district court order dissolving a bankruptcy court order enjoining a strike against the debtor by union employees seeking preferential payments. In so doing, the court noted that debtors do not have control over many economic factors that may affect the outcome of a reorganization case, and that legitimate tools (such as a strike authorized by applicable labor laws) that strip a debtor of economic power cannot be avoided simply because a debtor might be forced out of business. Return to article

¹⁴ See Southern Railway Co. v. Johnson Bronze Co. (In re Johnson Bronze Co.), 758 F.2d 138, 141 (3d Cir. 1985). Return to article

¹⁵ See Official Committee of Equity Holders v. Mabey, 832 F.2d 299, 302 (4th Cir. 1987) (reversing bankruptcy court order establishing emergency fund designed to pay medical expenses for Dalkon Shield claimants prior to the confirmation of a plan of reorganization). Return to article

¹⁶ In re Oxford Management Inc., 4 F.3d 1329, 1334 (5th Cir. 1993). This case involved the statutory priority scheme contained in §726. The Fifth Circuit has always taken a narrow view of §105, stating that the section neither creates substantive rights that are otherwise unavailable under applicable law nor constitutes a "roving commission to do equity." See United States v. Sutton, 786 F.2d 1305, 1308 (5th Cir. 1986). Payment of pre-petition claims other than through a plan is also arguably inconsistent with the Fifth Circuit's opinion in In re Aweco, which reversed a bankruptcy court's approval of a pre-confirmation compromise and settlement of an unsecured claim on the grounds that it violated the absolute priority rule. 725 F.2d 293 (5th Cir.), cert. denied, 469 U.S. 880, 105 S.Ct. 244, 83 L.Ed.2d 182 (1984). See In re CoServ L.L.C., 273 B.R. 487, 495 (Bankr. N.D. Tex. 2002). Return to article

¹⁷ See, e.g., In re Equalnet Communications Corp., 258 B.R. 368, 369-70 (Bankr. S.D. Tex. 2000) (enumerating four exceptions to prohibition); In re Tri-Union Dev. Corp., 253 B.R. 808 (Bankr. S.D. Tex. 2000); In re CoServ L.L.C., 273 B.R. at 496 (acknowledging prohibition and narrow exception involving three-part test for payment of critical vendor claims). Return to article

¹⁸ Letter from Hon. Peter J. Walsh to Delaware Bankruptcy Counsel of 4/2/98. Judge Walsh makes several points in his letter, which refers to DIP financing orders, about the scope of the recitations of findings, which he finds is often too broad given the opportunity he has to review the orders before the hearings. Judge Walsh makes a specific point to ask counsel not to include a finding that notice is sufficient and adequate in every order, because ‘[n]ine times out of 10 this is simply not true." 4/2/98 Letter at page 4. Return to article