Critical Vendor Motions

Critical Vendor Motions

The Bankruptcy Code does not expressly authorize payment of vendors' prepetition unsecured claims before plan confirmation. Courts that allow critical vendor motions rely on Sec. 105(a) and the 'doctrine of necessity,' a concept that developed from two rules that originally arose more than 120 years ago in railroad reorganization cases: the 6 months rule and the necessity of payment doctrine. In re Penn Central Trans. Co., 458 F. Supp. 1234, 1319-28 (E.D. Pa, 1978), aff'd in part and remanded in part, 596 F2d 1102 (3rd Cir. 1979).

The 6 months rule was first articulated by the U.S. Supreme Court in Fosdick v. Schall, 99 U.S. 235 (1878). The rule gives priority to prepetition unsecured claims, over secured claims, of creditors that provided essential services to a railroad's operations. The priority is extended to unsecured claims that, as of the petition date, were due and payable within 6 months prior to a railroad's bankruptcy filing.

The rationale for the 6 months rule, which is considered equitable in nature, is that '[r]evenues accruing from operations should be paid first to the operations creditors whose material and services made those revenues possible; and only after all such operational claims have been paid, should the balance be available for the benefit of the mortgagees.' In re New York, N.H. & H.R.R., 278 F. Supp. 592, 597-98 (D. Conn. 1967), aff'd, 405 F.2d 50 (2d Cir. 1968), cert. denied, 394 U.S. 999 (1969).

The 6 months rule has been codified at 11 U.S.C. ' 1171(b), which is part of Subchapter IV of Chapter 11 and applies just to railroad reorganizations. The necessity of payment rule or the 'doctrine of necessity' was first recognized by the Supreme Court 4 years after Fosdick in another railroad case, Miltenberger v. Logansport, 106 U.S. 286 (1882). This rule enables a debtor-railroad to make immediate prepetition payment to critical vendors that, absent payment, might refuse to supply goods and services and thus jeopardize the railroad's continuing viability. See, B&W Enters., Inc. v. Goodman Oil Co. (In re B&W Enters., Inc.), 713 F.2d 534, 537 (9th Cir. 1983); In re Boston & Marine Corp., 635 F.2d 1359, 1366-70 (1st Cir. 1980).

Division Among Courts

In non-railroad cases, some courts have utilized Sec. 105(a) and the doctrine of necessity to allow debtors to pay prepetition unsecured claims of vendors prior to confirmation of a Chapter 11 plan. Sec. 105(a) provides:

'The court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title. No provision of this title providing for the raising of an issue by a party in interest shall be construed to preclude the court from, sua sponte, taking any action or making any determination necessary or appropriate to enforce or implement court orders or rules, or to prevent an abuse of justice.'

Courts reason that payment of critical vendors' prepetition claims is sometimes crucial to fostering a successful reorganization. In re CoServ, LLC, 273 B.R. 487 (Bankr. N.D. Tex. 2002); In In re Wehrenberg, Inc., 260 B.R 468 (Bankr. E.D. Mo. 2001); In re Just for Feet Inc., 242 B.R. 821, 824-25 (Bankr. D. Del. 1999); see also In re Ionosphere Clubs, Inc., 98 B.R. 174, 175-177 (Bankr. S.D.N.Y. 1999) (dealing with prepetition unsecured employee claims). Courts caution, however, that critical vendor motions should be granted only in extraordinary circumstances. The court in CoServe, for instance, articulated a stringent three-part test. Debtors seeking to give priority to vendors' prepetition claims should show by a preponderance of the evidence that: 1) it is essential for the debtor to deal with the vendor; 2) unless the debtor deals with the vendor, the debtor risks the probability of harm, or alternatively, loss of economic advantage to the estate or the debtor's going concern value; and 3) there is no practical or legal alternative by which the debtor can deal with the vendor other than by paying the vendor's prepetition claim. In re CoServ, LLC, 273 B.R at 498. See also In re Just for Feet, Inc., 242 B.R. at 826 (requiring a debtor to demonstrate that payment to a critical vendor is crucial to the debtor's reorganization).

Other courts have refused to grant critical vendor motions. According to those courts, Sec. 105(a) does not authorize the payment of vendors' prepetition claims in non-railroad cases. Matter of Oxford Mgmt., Inc., 4 F.3d 1329, 1333-34 (5th Cir. 1993); In the Matter of B&W Enters., Inc., 713 F.2d 534, 535-37 (9th Cir. 1983); In re Timberhouse Post and Beam, Ltd., 196 B.R. 547, 550-51 (D. Mont. 1996); In re FCX, Inc., 60 B.R. 405, 409-10 (E.D.N.C. 1986). Those courts have reasoned that 1) the allowance of critical vendor motions effectively permits a debtor to reorder the priority of creditor claims in a manner not prescribed by Bankruptcy Code Sec. 507; and 2) Congress has not authorized the payment of critical vendor motions in Sec. 105(a) or elsewhere in the Bankruptcy Code.

Capital Factors v. Kmart

In Capital Factors v. Kmart, the retailer filed several first-day motions seeking permission to pay prepetition unsecured claims of certain critical vendors, liquor vendors and foreign vendors (collectively, the 'critical vendor motions'). Capital Factors, Inc., a factoring agent for a number of Kmart's apparel suppliers and holder of general unsecured claims against Kmart, objected to the critical vendor motions. The bankruptcy court, relying on Sec. 105(a), overruled Capital's objections and granted the motions.

Capital appealed, arguing, inter alia, that Sec. 105(a) does not authorize a debtor to pay selected prepetition unsecured creditors prior to Chapter 11 plan confirmation. District Judge John F. Grady agreed with Capital. With respect to Sec. 105(a), Judge Grady noted that the Seventh Circuit Court of Appeals has stated, 'Bankruptcy courts [can] use their equitable powers only as necessary to enforce the provisions of the Code, not to add to it as they see fit.' Id., 291 B.R. at 822 (quoting In re Fesco Plastics Corp., 996 F.2d 152, 156 (7th Cir. 1993)). Provisions of Code Secs. 503 and 507 are ignored when critical vendor motions are granted, Judge Grady concluded. 291 B.R. at 822.

Judge Grady further stated that 'however useful and practical these [critical vendor] payments may appear to bankruptcy courts, they simply are not authorized by the Bankruptcy Code. Congress has not elected to codify the doctrine of necessity or otherwise permit pre-plan payment of prepetition unsecured claims.' Id. at 823.

Kmart also did not convince Judge Grady that Capital's appeal was moot. Kmart asserted, inter alia, that the appeal should be deemed 'equitably moot' because it would 'paralyze' Kmart if it had to sue the vendors to seek the return of hundreds of millions of dollars already paid to thousands of vendors. Judge Grady rejected Kmart's 'doomsday speculations' that Kmart would have to sue to recover the payments. 'Kmart cites no cases indicating that the bankruptcy court would not have the power to order the return of monies paid.' 291 B.R at 824.

Kmart and other critical vendor decisions have important implications for bankruptcy practitioners. First, before a bankruptcy petition is filed, the debtor's counsel should determine if the courts where the petition could be filed are likely or unlikely to grant a critical vendor motion and how such a decision could impact the debtor's efforts to reorganize in Chapter 11.

Second, counsel for a creditor that receives payment pursuant to a critical vendor motion should be mindful that the creditor might have to return such a payment to the debtor's bankruptcy estate if the bankruptcy court's order is reversed.

Daniel A. Lowenthal III is a partner in the bankruptcy and reorganization practice group at Thelen Reid & Priest LLP in New York. Peter V. Marchetti is an associate in that group.

Chapter 11 debtors often file motions, usually at the outset of a case, that seek to pay prepetition unsecured amounts owed to 'critical' vendors that supply debtors with essential goods and services. Debtors argue that, unless such motions are granted, vendors will cease supplying them, and thus jeopardize the their ability to reorganize. Court orders that grant critical vendor motions require vendors to continue supplying debtors on specified business terms in return for payment of the prepetition amounts owed.

Some courts grant critical vendor motions, while others do not. Courts that grant the motions typically cite Bankruptcy Code Sec. 105(a) and principals of equity in support of their decisions. Courts that deny the motions often conclude that 1) the Bankruptcy Code does not authorize payment of vendors' prepetition claims prior to confirmation of a Chapter 11 plan, and 2) the payment of such claims ignores the priority scheme set up by Congress in the Bankruptcy Code.

In April, a district judge in the Kmart Corporation bankruptcy case reversed a bankruptcy court's decision that let Kmart pay millions of dollars to critical vendors. Capital Factors, Inc. v. Kmart Corp. , 291 B.R. 818 (N.D. Ill. 2003). At press time, Kmart was appealing the decision to the Seventh Circuit Court of Appeals. If the decision stands, Kmart will likely need to seek the return of the monies already paid to thousands of vendors.

Critical Vendor Motions

The Bankruptcy Code does not expressly authorize payment of vendors' prepetition unsecured claims before plan confirmation. Courts that allow critical vendor motions rely on Sec. 105(a) and the 'doctrine of necessity,' a concept that developed from two rules that originally arose more than 120 years ago in railroad reorganization cases: the 6 months rule and the necessity of payment doctrine. In re Penn Central Trans. Co., 458 F. Supp. 1234, 1319-28 (E.D. Pa, 1978), aff'd in part and remanded in part, 596 F2d 1102 (3rd Cir. 1979).

The 6 months rule was first articulated by the U.S. Supreme Court in Fosdick v. Schall , 99 U.S. 235 (1878). The rule gives priority to prepetition unsecured claims, over secured claims, of creditors that provided essential services to a railroad's operations. The priority is extended to unsecured claims that, as of the petition date, were due and payable within 6 months prior to a railroad's bankruptcy filing.

The rationale for the 6 months rule, which is considered equitable in nature, is that '[r]evenues accruing from operations should be paid first to the operations creditors whose material and services made those revenues possible; and only after all such operational claims have been paid, should the balance be available for the benefit of the mortgagees.' In re New York, N.H. & H.R.R. , 278 F. Supp. 592, 597-98 (D. Conn. 1967), aff'd , 405 F.2d 50 (2d Cir. 1968), cert. denied , 394 U.S. 999 (1969).

The 6 months rule has been codified at 11 U.S.C. ' 1171(b), which is part of Subchapter IV of Chapter 11 and applies just to railroad reorganizations. The necessity of payment rule or the 'doctrine of necessity' was first recognized by the Supreme Court 4 years after Fosdick in another railroad case, Miltenberger v. Logansport , 106 U.S. 286 (1882). This rule enables a debtor-railroad to make immediate prepetition payment to critical vendors that, absent payment, might refuse to supply goods and services and thus jeopardize the railroad's continuing viability. See, B&W Enters., Inc. v. Goodman Oil Co. (In re B&W Enters., Inc.), 713 F.2d 534, 537 (9th Cir. 1983); In re Boston & Marine Corp., 635 F.2d 1359, 1366-70 (1st Cir. 1980).

Division Among Courts

In non-railroad cases, some courts have utilized Sec. 105(a) and the doctrine of necessity to allow debtors to pay prepetition unsecured claims of vendors prior to confirmation of a Chapter 11 plan. Sec. 105(a) provides:

'The court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title. No provision of this title providing for the raising of an issue by a party in interest shall be construed to preclude the court from, sua sponte, taking any action or making any determination necessary or appropriate to enforce or implement court orders or rules, or to prevent an abuse of justice.'

Courts reason that payment of critical vendors' prepetition claims is sometimes crucial to fostering a successful reorganization. In re CoServ, LLC, 273 B.R. 487 (Bankr. N.D. Tex. 2002); In In re Wehrenberg, Inc., 260 B.R 468 (Bankr. E.D. Mo. 2001); In re Just for Feet Inc., 242 B.R. 821, 824-25 (Bankr. D. Del. 1999); see also In re Ionosphere Clubs, Inc., 98 B.R. 174, 175-177 (Bankr. S.D.N.Y. 1999) (dealing with prepetition unsecured employee claims). Courts caution, however, that critical vendor motions should be granted only in extraordinary circumstances. The court in CoServe, for instance, articulated a stringent three-part test. Debtors seeking to give priority to vendors' prepetition claims should show by a preponderance of the evidence that: 1) it is essential for the debtor to deal with the vendor; 2) unless the debtor deals with the vendor, the debtor risks the probability of harm, or alternatively, loss of economic advantage to the estate or the debtor's going concern value; and 3) there is no practical or legal alternative by which the debtor can deal with the vendor other than by paying the vendor's prepetition claim. In re CoServ, LLC, 273 B.R at 498. See also In re Just for Feet, Inc., 242 B.R. at 826 (requiring a debtor to demonstrate that payment to a critical vendor is crucial to the debtor's reorganization).

Other courts have refused to grant critical vendor motions. According to those courts, Sec. 105(a) does not authorize the payment of vendors' prepetition claims in non-railroad cases. Matter of Oxford Mgmt., Inc., 4 F.3d 1329, 1333-34 (5th Cir. 1993); In the Matter of B&W Enters., Inc., 713 F.2d 534, 535-37 (9th Cir. 1983); In re Timberhouse Post and Beam, Ltd., 196 B.R. 547, 550-51 (D. Mont. 1996); In re FCX, Inc., 60 B.R. 405, 409-10 (E.D.N.C. 1986). Those courts have reasoned that 1) the allowance of critical vendor motions effectively permits a debtor to reorder the priority of creditor claims in a manner not prescribed by Bankruptcy Code Sec. 507; and 2) Congress has not authorized the payment of critical vendor motions in Sec. 105(a) or elsewhere in the Bankruptcy Code.

Capital Factors v. Kmart

In Capital Factors v. Kmart, the retailer filed several first-day motions seeking permission to pay prepetition unsecured claims of certain critical vendors, liquor vendors and foreign vendors (collectively, the 'critical vendor motions'). Capital Factors, Inc., a factoring agent for a number of Kmart's apparel suppliers and holder of general unsecured claims against Kmart, objected to the critical vendor motions. The bankruptcy court, relying on Sec. 105(a), overruled Capital's objections and granted the motions.

Capital appealed, arguing, inter alia, that Sec. 105(a) does not authorize a debtor to pay selected prepetition unsecured creditors prior to Chapter 11 plan confirmation. District Judge John F. Grady agreed with Capital. With respect to Sec. 105(a), Judge Grady noted that the Seventh Circuit Court of Appeals has stated, 'Bankruptcy courts [can] use their equitable powers only as necessary to enforce the provisions of the Code, not to add to it as they see fit.' Id., 291 B.R. at 822 (quoting In re Fesco Plastics Corp., 996 F.2d 152, 156 (7th Cir. 1993)). Provisions of Code Secs. 503 and 507 are ignored when critical vendor motions are granted, Judge Grady concluded. 291 B.R. at 822.

Judge Grady further stated that 'however useful and practical these [critical vendor] payments may appear to bankruptcy courts, they simply are not authorized by the Bankruptcy Code. Congress has not elected to codify the doctrine of necessity or otherwise permit pre-plan payment of prepetition unsecured claims.' Id. at 823.

Kmart also did not convince Judge Grady that Capital's appeal was moot. Kmart asserted, inter alia, that the appeal should be deemed 'equitably moot' because it would 'paralyze' Kmart if it had to sue the vendors to seek the return of hundreds of millions of dollars already paid to thousands of vendors. Judge Grady rejected Kmart's 'doomsday speculations' that Kmart would have to sue to recover the payments. 'Kmart cites no cases indicating that the bankruptcy court would not have the power to order the return of monies paid.' 291 B.R at 824.

Kmart and other critical vendor decisions have important implications for bankruptcy practitioners. First, before a bankruptcy petition is filed, the debtor's counsel should determine if the courts where the petition could be filed are likely or unlikely to grant a critical vendor motion and how such a decision could impact the debtor's efforts to reorganize in Chapter 11.

Second, counsel for a creditor that receives payment pursuant to a critical vendor motion should be mindful that the creditor might have to return such a payment to the debtor's bankruptcy estate if the bankruptcy court's order is reversed.

Daniel A. Lowenthal III is a partner in the bankruptcy and reorganization practice group at Thelen Reid & Priest LLP in New York. Peter V. Marchetti is an associate in that group.