Who would have thunk it? Just when practitioners get bankruptcy judges properly trained, some appellate court steps in and messes it all up. We all know that so-called "critical vendor" orders have become standard procedure in any operating company chapter 11 proceeding. They are so commonplace that most firms that do a substantial amount of debtor work have emergency motions (along with accompanying affidavits) on their word processors, ready to go. At one time, the post-petition payment in the ordinary course of business of pre-petition, unsecured trade suppliers to maintain their goodwill and thereby maintain the going-concern value of the distressed company would have been truly extraordinary (and in many jurisdictions, still is). Now it has become an inalienable right of debtors and trade vendors alike.

So what happens when a debtor, in the exercise of its business judgment, decides that while all vendors may be critical at one level or another, some vendors are more critical than others? Therein lies the cautionary tale of Capital Factors Inc. v. Kmart Corp., issued on April 8, 2003, by the U.S. District Court for the Northern District of Illinois. Capital Factors arose from an appeal from four first-day, critical vendor orders of the bankruptcy court issued in late January 2002 in Kmart's reorganization. These orders authorized the debtor to pay, at its discretion, in excess of $320 million to pre-petition vendors (both foreign and domestic), liquor distributors and advertising companies—all, in the estimation of the debtor's management, "critical vendors" without whose goodwill and support Kmart could not effectively reorganize.

One pre-petition unsecured creditor that did not make the list took umbrage at Kmart's motion.¹ Capital Factors, a factoring company with an unsecured claim of about $20 million, had the audacity to object to Kmart's critical vendor motion. Its objection was, not surprisingly, denied by the bankruptcy court. Although Capital Factors took an appeal of the bankruptcy court's decision, it did not obtain a stay of the bankruptcy court's first-day orders; Kmart paid out approximately $327 million in pre-petition vendor claims.

After conducting oral argument, the district court issued its decision the week before Kmart was about to confirm its plan in Capital Factors. The district court's decision likely surprised everyone—including Capital Factors. The district court reversed all four of the bankruptcy court's first-day orders regarding the "critical vendors" and remanded the matter back to the bankruptcy court to essentially order the return of all the money paid to these vendors. The decision illuminates what may have been a dirty little secret in the bankruptcy community—i.e., while first-day orders are clearly customary in bankruptcy cases, the articulated legal basis for such motions may often be suspect.

Kmart relied on the tried and true legal bases for critical-vendor motions—the "doctrine of necessity" and the ever-popular Bankruptcy Code §105, which outlines the general equitable powers of the bankruptcy court. Moreover, Kmart asserted that since Capital Factors never obtained a stay of the first-day orders pending appeal, and since hundreds of millions of dollars had been paid to these creditors in reliance on the court order, the doctrine of "equitable mootness" precluded the district court from granting relief to Capital Factors.

The district court pointed out that the "doctrine of necessity" arose from railroad reorganization cases, and simply does not exist in the current Bankruptcy Code. In addition, the district court held that §105 does not give a bankruptcy court, regardless of its good intentions, the authority to ignore or otherwise expand upon the Bankruptcy Code by creating its own priorities. Moreover, the phrase "equitable mootness" had been banned from the legal lexicon by the Seventh Circuit.² The district court dismissed Kmart's argument that the decision would require it to commence hundreds of recovery lawsuits: It held that the bankruptcy court could simply order the vendors to return the money.

The timing of the district court decision is in and of itself extraordinary. The court ruled about 15 months after the beginning of the case, and certainly well over a year after the payments had been made to the vendors. Apparently, the court ignored the current posture of the case—namely, that the debtor was heading into a confirmation proceeding in which creditors had already been solicited pursuant to a court-approved disclosure statement.³ Presumably none of these critical vendors had been solicited because, by virtue of having been paid under the first-day orders, they no longer held pre-petition claims. The adequacy of disclosure issues alone boggles the mind.

Another notable element of Capital Factors is the court's lack of attention to the articulated legal bases for the first-day motion. On appeal, the primary letter-of-credit issuer for Kmart's foreign suppliers argued that the bankruptcy court clearly had legal authority to issue the orders based on its ability to approve adequate protection for the letter of credit issuers under Code §361. The argument went that since the letters of credit in that case were secured (consensually or by operation of law), the bankruptcy court could have approved payment to the critical vendors as a means of adequately protecting the letter of credit issuer (so draws could not be made by foreign suppliers on the letters of credit). Since this argument had not been raised at the bankruptcy-court level, the district court would not consider it for the first time on appeal.⁴

The district court also held that while these first-day orders are certainly well-intentioned, the bankruptcy court simply had not cited any pertinent authority to support an extraordinary order that elevated hundreds of millions of dollars of general unsecured pre-petition claims above others, and if there was going to be a fix of this problem, it has to come from Congress and not the courts. While this is true as far as it goes, there is also no new cash exception to the absolute priority rule found in the Bankruptcy Code, yet at least two circuit courts of appeal (including, interestingly, Chicago's own Seventh Circuit) have recognized its continued viability under the Code even though it is a 1930s-era judge-made doctrine, and the Supreme Court (despite three opportunities) has never ruled otherwise.⁵

Kmart appealed the Capital Factors decision to the Seventh Circuit on April 10, 2003.⁶ The adverse decision notwithstanding, Kmart pressed on with confirmation of its plan. The bankruptcy court denied emergency motions from, among others, Capital Factors, to delay the confirmation in light of the district court decision, and proceeded to a contested confirmation hearing involving numerous objections. After the dust cleared on April 22, 2003, the bankruptcy court ruled on 188 objections and confirmed the plan.⁷ Will Capital Factors appeal the confirmation ruling? No: Kmart finally settled with Capital Factors on its confirmation objection.⁸

The lessons that come from the Capital Factors decision may be summarized:

• Hell clearly hath no fury like a vendor that doesn't make the critical vendor cut. It is indeed ironic that a pre-petition vendor owed $20 million (which, in the scheme of the Kmart case was truly a small claim) can create the sort of headaches that Capital Factors caused not only in the Kmart case, but also in the restructuring environment in Chicago. Although the national debate about venue-shopping continues, any experienced practitioner knows that you stay away from jurisdictions that have bad law. From the debtor's perspective, Capital Factors is very bad law indeed.⁹
• The concept of "critical vendors" has gone from an extraordinary remedy to something that is simply done as a matter of course in almost all cases. It is clearly subject to abuse, and vendors frequently jockey for a place on the critical-vendor list. Sometimes that helps a debtor immensely (as it may be able to extract concessions and extension of post-petition trade debt in exchange for adding a creditor to the "list"), but it is frequently viewed as an entitlement by trade creditors. The unfortunate aspect of this is simply that the decision reaches all vendors—the truly "critical" (such as the blood supplier to a hospital and fuel supplier to an airline) where there really are very limited, if any, choices for substitution, as well as the pseudo-critical vendors who simply scream the loudest to get on the list.
• The district court's recitation of the legal basis asserted by Kmart in its first-day motions presents an interesting cautionary tale. There are a number of legal grounds that could have been asserted to support the critical-vendor motion, but apparently none was. Previously discussed was the adequate-protection argument raised by the letter-of-credit issuer (which was not raised as a legal basis in the first-day motions). Another arguable legal basis to support the relief requested in the critical-vendor motion would be the bankruptcy court's powers to approve post-petition financing under Code §364. While that argument was indirectly dismissed in Capital Factors,¹⁰ would it have made any difference to a reviewing court if the bankruptcy court had based its authority to issue the critical-vendor orders on whether the debtor's payment of critical vendors had been conditioned on the critical vendor's agreeing to extend post-petition, debtor-in-possession financing pursuant to Code §364(b)? Observers can only speculate, but that is certainly an arguable basis to allow or to support the payment of pre-petition claims that were not raised in the initial motions (at least outside the Third, Sixth and Eleventh Circuits).
• "Bad facts make bad law" is an old saw. Equally true is that bad dynamics also make bad law. Outsiders can only guess why Kmart didn't settle with Capital Factors right after the appeal was filed. Arrogance? "You're too small to waste my settlement time" mentality? Steadfast belief that no district court would overturn an order as commonplace in chapter 11 cases? Maybe some of all of the above. One thing is certain—leaving an aggrieved party with no alternative but to pursue appellate rights can result in unpleasant surprises.
• It is important to note that there were numerous first-day orders entered in the case, including payment of pre-petition employee claims, that were not appealed. Pre-petition employee claims do have legal rights different than trade vendor claims at least as to the statutory priority under Code §507(a)(3).
• Finally, there are those in the practice (and on the bench) who would argue that if critical-vendor motions went away tomorrow, while it would create a transition period of uncertainty, the earth would not spin off its axis and collide into the sun. In fact, many vendors who threaten to withhold post-petition deliveries (even on a COD basis), based on the fact that they have an unpaid pre-petition claim, would more than likely ship post-petition (certainly if there was a reasonable debtor-in-possession financing facility that gave them comfort) even without payment on their claims. Of course, no debtor's counsel wants to call their bluff, because the consequences are severe. Indeed, there are a million other fires burning at the outset of a chapter 11, and the critical-vendor first-day motions (and orders) may have simply become an expedient fire extinguisher to douse one blaze.

So what does the future hold? Who knows—the district court in Chicago is one of many, and unless Kmart settles with Capital Factors in such a way that results in dismissal of the appeal, it is possible that this dispute might have to be resolved by the Seventh Circuit. It may even eventually reach the Supreme Court. Will Chicago lose its recently acquired, coveted place as the haven for big cases? Maybe, maybe not. The real problem (in the author's humble opinion) is that the exception to the rule (payment of unsecured, pre-petition trade debt) has become the rule. Expectations have been created—and now dashed. As recognized by Homer centuries ago, "Zeus does not bring all men's plans to fulfillment."¹¹ So be it; lawyers are nothing if not adaptable. If Capital Factors becomes the widespread law of the land, new expectations will need to be formed.

Footnotes

¹ Interestingly, in its first-day motion, Kmart (with few exceptions) did not specifically list vendors that it would consider "critical" and that it would not. It simply sought bankruptcy court approval to pay, in the aggregate, hundreds of million of dollars in pre-petition vendor claims (by general category) in the ordinary course of its business in its discretion. In addition, the vendor order gave the debtor discretion to cut deals with creditors. It was the bankruptcy equivalent of a writ from the King.

² See In re UNR Ind. Inc., 20 F.3d 766 (7th Cir. 1994).

³ The district court was embroiled in a lengthy, 10-defendant criminal trial involving corruption in Cicero, Ill. Hence, the delay.

⁴ This is sometimes referred to as the judicial "neener, neener" rule, also known as the "judicial raspberry" edict.

⁵ See Case v. Los Angeles Lumber, 308 U.S. 106, reh'g. denied, 308 U.S. 637 (1939). The Supreme Court has had at least three opportunities over the last 15 years to rule that any new cash exception to the absolute priority rule must come from Congress, and has steadfastly refused to do so. See Salerno, Kroop & Hansen, "Urgent Message to the Supreme Court: 'Just Do It!,'" 24 BCD Weekly News and Comment, A1 (May 25, 1999).

⁶ Why the Capital Factors order isn't interlocutory (given the remand mandate) escapes the author.

⁷ To at least give lip service to Capital Factors, Kmart amended its plan at the confirmation hearing to provide for retained jurisdiction over avoidance actions—something the filed/solicited plan did not contain (in fact, Kmart's original plan expressly waived avoidance actions, which is sometimes done in retail cases to get owner/supplier relationships normalized quickly post-confirmation). Accordingly, reorganized Kmart or its assignee could still comply with Capital Factors's mandate on remand—just post-confirmation.

⁸ This saved Kmart from two appeals—one for denial of the emergency motion, and the other for denial of the confirmation objection.

⁹ In fact, some commentators are already heralding the Capital Factors decision as the death knell for the filing of large chapter 11 cases in Chicago. See Kaiser, "Chicago's Bankruptcy Boom Short-lived?," Reuters News Release, April 27, 2003 (with counsel for Kmart assailing the opinion as "one of the harshest opinions of this kind in this country."). Time (and perhaps the Seventh Circuit) will tell.

¹⁰ Capital Factors at 7, n.6. The district court noted that three circuit courts have already decided that §364 does not allow even a secured creditor (much less an unsecured creditor) to cross-collateralize pre- and post-petition debt under §364, or otherwise permit payment of pre-petition claims as part of post-petition financing. In re Saybrook Mfg. Co., 963 F.2d 1490 (11th Cir. 1992); In re Johnson Bronze Co., 758 F.2d 138 (3rd Cir. 1985); In re Crowe & Assoc. Inc., 713 F2d 211 (6th Cir. 1983) (dicta). Whether §364 could support payment of pre-petition unsecured debt as a condition to extension of post-petition unsecured debt is certainly debatable. Indirectly, Kmart's first-day motions might have been construed as being a §364 motion since all critical vendors were required to extend trade terms, although §364 was not specifically listed as a legal basis for the first-day orders.

¹¹ The Iliad, XVIII, line 328 (700 B.C.).