The Doctrine of Necessity and Critical Trade Vendors The Impracticality of Maintaining Post-petition Business Relations in Mega-cases

The Doctrine of Necessity and Critical Trade Vendors The Impracticality of Maintaining Post-petition Business Relations in Mega-cases

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When a corporate debtor files its chapter 11 petition, it usually includes a barrage of emergency "first-day motions." To prevent the disruption of business, a common first-day motion is a Motion for Order Authorizing the Payment of Pre-Petition Claims of Critical Trade Vendors, a.k.a. the Critical Vendor Motion. A critical vendor motion seeks authority to pay the pre-petition claims of those vendors that the debtor deems critical to the operation of its business, in contradiction to the basic premise of equal distribution to similarly situated creditors under the Bankruptcy Code.

The premise for such a motion is that if the debtor does not satisfy all or part of a critical trade vendor's pre-petition debt, that vendor may sever business relations with the debtor. After all, we want to encourage vendors to conduct business with debtors-in-possession to minimize operational disruptions.

It is this goal that led to the creation of the doctrine of necessity, the support for the relief requested in a critical vendor motion. However, critical vendor motions have recently come under close scrutiny. See In re CoServ L.L.C., 273 B.R. 487, 492-93 (Bankr. N.D. Tex. 2002). This scrutiny has resulted in strict evidentiary prerequisites for granting such relief. Unfortunately, these prerequisites are impractical for today's mega-cases, as well as for emergency first-day hearings, leading some to believe that perhaps Congress should officially codify the doctrine of necessity.

The Doctrine of Necessity

The doctrine of necessity stems from the "Six Months Rule." The Six Months Rule arose in railroad receiverships to allow receivers to pay recently incurred debts in order to continue business operations. See In re CoServ L.L.C., 273 B.R. at 492-93; citing Eisenberg, Russell A., and Geckner, Frances F., "The Doctrine of Necessity and its Parameters," 73 MARQ. L. REV. 1 (1989) (citing In re B&W Enterprises Inc., 713 F.2d 534, 536 (9th Cir. 1983). The Six Months Rule later became codified in the Bankruptcy Act as §77(b), and subsequently survived the enactment of the Bankruptcy Code as §1171(b). However, §1171(b) applies only to railroad reorganizations, not all chapter 11 reorganizations.

Like the Six Months Rule, the doctrine of necessity arose from railroad reorganizations, based partially on the equitable considerations of §77(b) and subsequently §1171(b), to insure the continued supplies and services essential to operations. Id.; citing B & W Enterprises, 713 F.2d at 537 (where the Ninth Circuit declined to extend the doctrine of necessity, then referred to as the Necessity of Payment Rule, to non-railroad cases). By its own terms, however, §1171(b) does not apply to all chapter 11 cases.

[T]he doctrine, as it now stands, is not the invitation to an open checkbook that some assert.

Nonetheless, certain courts have applied the doctrine of necessity to non-railroad bankruptcies, citing the ever-popular, and apparently omnipotent, §105(a). See In re Just for Feet Inc., 242 B.R. 821, 826 (D. Del. 1999) (citing In re Financial News Network Inc., 134 B.R. 732, 736 (Bankr. S.D.N.Y. 1991)); In re NVR L.P., 147 B.R. 126, 128 (Bankr. E.D. Va. 1992); In re Eagle-Picher Industries Inc., 124 B.R. 1021, 1023 (Bankr. S.D. Ohio 1991). Armed with §105(a), debtors cite the doctrine of necessity as black-letter law. And courts seeking to have their district appear "big chapter 11 friendly" embrace the doctrine of necessity, particularly in mega-cases where numerous vendors are allegedly critical.

While the application of the doctrine of necessity to non-railroad chapter 11 cases has benefited debtors by minimizing the disruption of business relations with vendors, a closer examination of cases extending the doctrine of necessity reveals that the doctrine, as it now stands, is not the invitation to an open checkbook that some assert.

Deciphering the Citations

The apparent elevation of the doctrine to black-letter law status is due in part to the common use of certain case cites in critical vendor motions. For example, In re Ionosphere Clubs Inc. is often cited for support of the application of the doctrine of necessity (98 B.R. 174 (Bankr. S.D.N.Y. 1989). Interestingly enough, Ionosphere Clubs supports the doctrine of necessity only in dicta, as the issue at hand was whether striking employees were entitled to the same treatment as non-striking employees. Although the court did authorize the payment of pre-petition wage claims, such claims are entitled to priority, which analysis differs for non-priority claims. See CoServ, 273 B.R. at 496; citing Ionosphere Clubs, 98 B.R. at 176.

While Ionosphere Clubs and other cases do support the use of estate assets for certain pre-petition claims, it is clear that such authorization has been limited to extreme circumstances, and only to the extent necessary to preserve the value of the debtor's bankruptcy estate. See CoServ, 273 B.R. at 496-98; Just for Feet, 242 B.R. at 825; Ionosphere Clubs, 98 B.R. at 175; Financial News, 134 B.R. at 736. Unfortunately, most such cases have provided little guidance as to the determination of necessity, resulting in a recent opinion establishing a three-pronged test. See CoServ, 273 B.R. at 498.

Obtaining Approval

In CoServ, the court found support for payment of pre-petition, non-priority unsecured claims in §105(a) and a debtor-in-possession's duties to "protect and preserve the estate." Id. at 496-97. As such, the court opined that authorization for payment of pre-petition, non-priority unsecured claims should come only after evidence that (1) the debtor must deal with the vendor, (2) a failure to deal with the vendor risks probable harm or eliminates an economic advantage disproportionate to the amount of the claim, and (3) the lack of a practical or legal alternative to payment. Id.

1. The Debtor Must Deal with the Vendor. To demonstrate that the vendor is a critical vendor, "a debtor must show that dealing with the [vendor] is virtually indispensable to profitable operations or preservation of the estate." Id. at 498. While CoServ expressly states that "the product and creditors having control over valuable property of the estate would satisfy this element," it only follows that other proof would suffice. For example, a demonstration that the vendor is the only supplier of an item in the area, or that the vendor is the only supplier of an item that can meet the debtor's specific time, cost, measurement or quality standard requirements, should be sufficient. Testimony that the vendor is the only one of its kind in a three-state area, and that such goods or services are the kind that are not deliverable by mail or courier, is a lot stronger evidence than testimony that the vendor is in close proximity to the debtor's office when the goods supplied are the kind that are typically delivered by the U.S. Mail.

Such evidence may be solicited from the debtor, but expert testimony on the industry and the debtor's needs in relation thereto may be necessary. The necessary evidence will be a case-specific inquiry, determined by the facts involved, but it is generally insufficient that the vendor and the debtor have an established relationship and/or that the debtor would have to establish a new account with another vendor. Most importantly, the debtor should submit evidence that the specific vendor is absolutely necessary, not just a vendor of the goods and services in issue.

2. A Failure to Deal with the Vendor Risks Probable Harm or Eliminates an Economic Advantage Disproportionate to the Amount of the Claim. Additionally, a debtor must demonstrate the net economic benefit and meaningful economic gain to the estate or the going-concern value of the debtor, or that the debtor will avoid serious economic harm through payment. Id. Indeed, merely showing that the vendor has established an account is insufficient. However, demonstrating a significant discount from the vendor (that no other vendor would offer) may suffice.

Again, such evidence needs to come from the debtor and perhaps an expert in the industry. While additional evidence from the vendor itself is preferable, many vendors are legally unsophisticated and are unlikely to voluntarily appear for testimony, particularly if any travel is involved. After all, if the vendor wanted to be cooperative, it would not require the payment of its pre-petition claim.

Courts should keep such evidentiary issues in mind when considering evidentiary objections, but allow the use of affidavits and even hearsay evidence to demonstrate the necessity of a debtor to deal with a particular vendor and the advantages of dealing with that particular vendor.

Furthermore, courts must consider the burdensome task of gathering evidence of the business relations between each "critical" vendor and the mega-debtor. Such vendors could aggregate to hundreds or even thousands. Contacting each such vendor to obtain affidavits or request live testimony is virtually impossible considering the strain management is already under. Thus, the practical ramifications of overly burdensome evidentiary requirements can be counter-productive in a mega-case.

3. The Lack of a Practical or Legal Alternative to Payment. As alternatives to payment, the CoServ court theorized that the existence of alternatives such as a deposit, COD or COO terms, or other devices would undermine a critical vendor motion. It is often these terms that a debtor seeks to avoid because of their potential economic impact. For example, a deposit requires an expenditure of cash in an amount specified by the vendor. Upon learning that its claim may not be paid, such deposit is likely to increase proportionate to the pre-petition claim. While such measures may be a violation of the Bankruptcy Code, they create hardship upon the debtor at a most crucial time.

Further, COO and COD are often the terms that a debtor seeks to avoid because of cash-flow issues. Therefore, the examination of such alternatives should be taken and presented in the context of the debtor's business and the industry as a whole. After all, certain industries are small, and word spreads quickly enough that slight pressure improves payment terms. Such extraneous factors must be kept in mind or else the application of such standards will result in a counter-productive marketplace for the debtor, and harm to the debtor's bankruptcy estate.

Alternatives will surely exist in every case, yet most are not feasible or are impractical for a debtor in bankruptcy. More importantly, consider the amount of time necessary for a mega-debtor to contact and negotiate with every vendor it deems critical. Whether to arrange payment alternatives or to gather evidence that no such alternatives exist, requiring such an expenditure of time is impractical, as would the payment alternatives due to the substantial amount of cash necessary to make deposits or operate on a COO or COD basis. In fact, avoiding such impractical alternatives is the major reason behind the filing of a critical vendor motion.

Problems of Proof and Conclusion

While the doctrine of necessity may or may not apply to all chapter 11 cases, the payment of pre-petition, non-priority claims is a reality for which relief can be granted when warranted. Proving that such relief is warranted, however, is the debtor's burden. As the debtor has that burden, it is only logical that the debtor present its case demonstrating why such relief is necessary and why no alternatives exist.

Of particular difficulty is the emergency filing where the debtor has critical trade vendors, yet has not had time to obtain affidavits or approach all of its critical vendors prior to a first-day hearing. First-day hearings, after all, are intended to provide relief to insure continued operations. But what does one do at the final hearing when the evidence is found not to have supported the interim relief?

While such considerations exist, the underlying goal of the Bankruptcy Code is to provide an opportunity for the debtor to reorganize. The opportunity to operate in furtherance of reorganization has been the premise for the Six Months Rule, the doctrine of necessity and the application of those doctrines to non-railroad chapter 11 cases. Because of such considerations, it is pertinent that Congress consider codifying the doctrine of necessity for all chapter 11 bankruptcy cases. In doing so, Congress should be mindful of the impact of strict guidelines for granting such relief and the importance of all practical considerations.

Journal Date: 
Sunday, September 1, 2002