The 'Doctrine of Necessity'

Most bankruptcy court orders applying the Doctrine are not appealed and are never published. Probable reasons for the failure of appellate review include the following: 1) strong probability of reorganization; 2) lack of resources; 3) payment coming from a secured creditor's collateral; and 4) the relatively small amount of the payment. Also, many first day orders are entered before creditors have organized, with little or no notice. See, e.g., Kmart, 2004 U.S. App. LEXIS 3397 at *1-*3.

Judicial rulings prior to Kmart fall into three camps: 1) those accepting the Doctrine; 2) those restricting application of the Doctrine; and 3) courts rejecting the Doctrine outright as a violation of the Code's priority and plan provisions.

Decisions Favorable to the Doctrine

The Doctrine is often associated with orders authorizing payment to “critical vendors,” but most of the published opinions favoring the Doctrine have been based on payment of employee benefits and wages. One district court upheld a bankruptcy court order empowering the debtors to pay prepetition wages, reimbursable expenses, health benefits, and the workers compensation claims of employees in some, but not all, states. In re Chateaugay Corp., 80 B.R. 279 (S.D.N.Y. 1987). The State of Michigan argued that this ruling discriminated within a class, in violation of Code ' 1122, and violated priority rules of Code ' 507. Relying on railroad cases and the bankruptcy court's equitable powers, the district court reasoned as follows:

A rigid application of the priorities of ' 507 would be inconsistent with the fundamental purpose of reorganization … [The] grant of equity powers to bankruptcy courts [was meant] to create a flexible mechanism that will permit the greatest likelihood of survival of the debtor and payment of creditors in full or at least proportionately. The Supreme Court has emphasized the special nature of reorganization [cases] …

Moreover, there is a serious question whether ' 507 applies at this stage of the bankruptcy [case] …

Also extending the reach and requirements of ' 1122 to preplan stages of the [case] would [be] inconsistent with the purpose of the [Code], limit the flexibility of the court and the debtor … '[T]he fact that bankruptcy courts are courts of equity … allows exceptions to any strict rules of classification of claims.' 80 B.R. at 287-88 (emphasis added) (citation omitted). This reasoning probably startled law professors and bankruptcy scholars at the time.

When Eastern Air Lines was authorized to pay prepetition wages, salaries, medical expenses and business expense claims of active employees, while denying the same payments to striking workers, In re Ionosphere Clubs, 98 B.R. 174 (Bankr. S.D.N.Y. 1989), the court found it “critical for [the debtor] to pay such pre-petition claims in order to preserve and protect its business and ultimately reorganize, retain its currently working employees and maintain positive employee morale.” Id. at 175 citing Dudley v. Mealey, 147 F.2d 268 (2d Cir. 1945), Code '' 105(a) and 363(b), and the Six Month Rule in the Railway Labor Act. The court also cited NLRB v. Bildisco & Bildisco, 465 U.S. 513 (1984), holding that “[t]he policy of equality among creditors … may be of significance in liquidation cases under Chapter 7, [but] the paramount policy and goal of Chapter 11, to which all other bankruptcy policies are subordinated, is the rehabilitation of the debtor.” Ionosphere, 98 B.R. at 176.

In In re Sharon Steel Corp., 159 B.R. 730 (Bankr. W.D. Pa. 1993), the court denied, on grounds of lack of standing, a stay pending appeal from an order to permit the sale of the debtor's steel inventory, with a portion of the proceeds reserved for prepetition union employees' wage claims. Grounding its ruling on the “Necessity of Payment” doctrine, the court held that the agreement with its union was necessary because the union's picket line was “essentially paralyzing the Debtor's operations,” posing a serious threat to the Chapter 11 process. Id. at 734. The court pointed to flat or falling steel prices, the expense incurred in holding the goods, the legitimacy of the workers' complaints, their constitutional right to picket and the need to quell them. It also observed that the appellant's failure to suggest a viable alternative means of liquidating the inventory amounted to tacit approval of the order.

The underlying rationale in these employee wage cases was summarized in In re Gulf Air, Inc., 112 B.R. 152 (Bankr. W.D. La. 1989). Stating that airline cases are analogous to the railroad cases that spawned the “Necessity of Payment” doctrine, the court permitted all pre-petition wages, health and life insurance premiums, worker's compensation premiums, and incurred expenses of the debtor airline's employees to be paid because “without immediate payment, many of the Debtor's skilled employees will abandon their employment, and … immediate payment is essential to reorganization efforts … [T]he Court must act immediately to safeguard against the loss of the going-concern values.” Id. at 153. Accord In re Federated Dep't Stores, Inc., 1990 Bankr. LEXIS 122, *9-*10 (Bankr. S.D. Ohio Jan. 15, 1990) (authorized payment of 1) prepetition employee wages, salaries and benefits; 2) payments to concessionaire lessees; and 3) payments to customers for refunds and deposits; payments were authorized because “[t]he success of these cases hinges on the Debtor's [sic] ability to preserve their relationships with employees, customers and department lessees and, therefore, on Debtors' ability to pay pre-petition claims as requested in the Motions.”)

Unfavorable Rulings Recognizing the Doctrine

In a moderating opinion, the court in In re Structurelite Plastics Corp., 86 B.R. 922 (Bankr. S.D. Ohio 1988), reviewed conflicting judicial authority concerning the Doctrine and found a middle ground. It denied payment to a health care trust fund for reimbursement of employee prepetition expenses for catastrophic illness despite arguments that employee morale would suffer. Id. According to the court, “permitting a Chapter 11 debtor to selectively pay pre-petition indebtedness serves to create priorities among the general unsecured creditor body that are inconsistent with the distributive scheme envisioned by ' 507. On the other hand, a per se rule proscribing the payment of pre-petition indebtedness may well be too inflexible to permit the effectuation of the rehabilitative purposes of the Code.” Id. at 932. The court envisioned rare instances when prepetition claims could be paid if absolutely vital to the reorganization and if the payment would maximize the ultimate interest of all creditors. Id.

Conceding that the “Necessity of Payment” rule is an established narrow exception to ' 507, the court in In re NVR, L.P., 147 B.R. 126 (Bankr. E.D. Va. 1992), refused to authorize payment of a prepetition incentive bonus to a terminated employee who was earning a considerable postpetition income as an outside consultant. Finding that the rule is one of necessity and not convenience, the court stated that “[u]nder 11 U.S.C. ' 105(a) the court can permit the pre-plan payment of a pre-petition obligation when essential to the continued operation of the debtor. However, ' 105 may not be used as a vehicle to discriminate among priority claims when there is no compelling business need for such discrimination.” Id. at 127 (citation omitted).

Cases Rejecting the Doctrine

Still other courts have rejected the Doctrine outright. In The Official Committee of Equity Security Holders v. Mabey (In re A.H. Robins Co.), 832 F.2d 299 (4th Cir. 1987), the Fourth Circuit reversed the district court's authorization for interim pre-plan payments to victims of the Dalkon Shield IUD for reconstructive surgery or for in vitro fertilization. The court explained that Code ' 105(a) did not furnish authority for an emergency treatment fund; that all distributions must be made only to approved claimants (the amounts of the claims were still being contested) through a confirmed plan; and that it was antithetical to the Code to prefer one unsecured creditor (requiring surgery or fertilization) over another (those not requiring medical intervention). Id. As the court stated, “[t]he creation of the [fund] has no authority to support it in the Bankruptcy Code and violates the clear policy of Chapter 11 reorganizations by allowing piecemeal, pre-confirmation payments to certain unsecured creditors.” Id. at 302.

In In re Revco D.S., Inc., 91 B.R. 777 (Bankr. N. D. Ohio 1988), the court denied the debtor authorization to pay prepetition trust fund taxes. The debtor's officers were personally threatened with liability for the arrearage, and the debtors argued that this threat was demoralizing to the company. The debtor also stressed that the tax liability was a priority claim that would have to be paid in a confirmed reorganization plan. Rejecting the debtor's arguments, the court ruled that equality of all unsecured creditors and payment only under a plan were mandatory under the Code. It added that ' 507(a)(7) afforded no greater priority to the trust fund taxes than to other taxes, and that permitting the debtor to cave into threats would supply taxing authorities with a reliable means of bypassing established bankruptcy procedures. See In re FCX, Inc., 60 B.R. 405 (E.D.N.C. 1986), (district court, when reversing bankruptcy court's order authorizing payment of prepetition claims to employees and grain producers, rejected argument that all unsecured creditors were expected to be paid, nor did court accept argument that going concern value of debtor would be lost if requested payments were not made; even in emergency situations, absent express authorization by Code, ' 507 priorities must be followed; despite bankruptcy court's equitable powers, “[t]he court cannot use this flexibility … merely to establish a ranking of priorities within priorities … [A]bsent the existence of some type of inequitable conduct … the court cannot subordinate a claim to claims within the same class.”).

The Rebirth of the 'Doctrine of Necessity'

The Doctrine of Necessity, justifying payment of “critical vendors,” has resurfaced in reorganization cases over the last 10 years. Debtors routinely sought critical vendor protection for favored domestic vendors who were their major suppliers. In the preceding 90 years, though, debtors found ways to pacify major suppliers and thus maintain an adequate supply of inventory. Debtors and their counsel now decided that it would be easier to pay their major suppliers. As a result, major suppliers began to insist on “critical vendor” status at the outset of the case.

Debtors and their ingenious counsel then went further. They sought to pay unnamed critical vendors up to a dollar limitation (ie, the amount to which their lenders would agree). One became a critical vendor by simply agreeing to provide unsecured credit to the debtor up to the amount of the pre-petition payment. This was, in fact, “a condition of payment for pre-petition debts” in Kmart 2004 U.S. App. LEXIS 3397 at *6. Although there is arguably some risk in extending credit to a Chapter 11 debtor, converting a pre-petition unsecured claim into a Chapter 11 administrative claim became highly attractive. The Doctrine thus became a gimmick for debtors to obtain post-petition credit.

The Doctrine Lacks a Basis in the Code

One can dress up payments to prepetition creditors with ' 105(a) or any other section of the Code, but “still the emperor has no clothes.” Section 105(a) authorizes the court to issue “any order … that is necessary or appropriate to carry out the provisions of this title.” But no provisions in the Code have to be carried out by using the Doctrine, as the Seventh Circuit stressed in Kmart:

This does not create discretion to set aside the Code's rules about priority and distribution; the power conferred by ' 105(a) is one to implement rather than override. See Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 206, 99 L. Ed. 2d 169, 108 S. Ct. 963 (1988); In re Fesco Plastics Corp., 996 F.2d 152, 154 (7th Cir. 1993). Cf. United States v. Noland, 517 U.S. 535, 542, 134 L. Ed. 2d 748, 116 S. Ct. 1524 (1996). Every circuit that has considered the question has held that this statute does not allow a bankruptcy judge to authorize full payment of any unsecured debt, unless all unsecured creditors in the class are paid in full. See In re Oxford Management, Inc., 4 F.3d 1329 (5th Cir. 1993); Official Committee of Equity Security Holders v. Mabey 832 F.2d 299 (4th Cir. 1987); In re B&W Enterprises, Inc., 713 F.2d 534 (9th Cir. 1983). We agree with this view of ' 105. 'The fact that a [bankruptcy case] is equitable does not give the judge a free-floating discretion to redistribute rights in accordance with his personal views of justice and fairness, however enlightened those views may be.' In re Chicago, Milwaukee, St. Paul & Pacific R.R., 791 F.2d 524, 528 (7th Cir. 1986).

2004 U.S. App. LEXIS 3397 at *10-*11. This reasoning applies to critical vendor orders and beyond.

There may be equitable reasons why critical payments must be made. Courts may understandably try to save a business during the early stages of a reorganization. Nobody can predict whether a business can or will be reorganized. See generally, Eisenberg R, Gecker F: The Doctrine of Necessity and Its Parameters, 73 Marq. L. Rev. 1 (1989) (“Creditors realize that it is in their best interests to permit certain prepetition creditors to be paid immediately, for if those creditors are not paid at once, everyone will suffer.”); Festerson: Equitable Powers in Bankruptcy Rehabilitation: Protection of the Debtor and the Doomsday Principle, 46 Am. Bankr. L.J. 311, 317 (1972) (when strict construction of governing statute may force deserving debtor to brink of disaster, courts have frequently found creative solutions; the greater the crisis, the more likely that courts will use equitable power to grant pragmatic relief). In Kmart, however, the debtor failed even to make the proper record:

The court did not find that any firm would have ceased doing business with Kmart if not paid for pre-petition deliveries, and the scant record would not have supported such a finding had one been made. The court did not find that discrimination among unsecured creditors was the only way to facilitate a reorganization. It did not find that the disfavored creditors were at least as well off as they would have been had the critical-vendors order not been entered …

Even if ' 36[3](b)(1) allows critical vendors orders in principle, preferential payments to a class of creditors are proper only if the record shows the prospect of benefit to the other creditors. This record does not, so the critical vendors order cannot stand.

2004 U.S. App. LEXIS 3397 at *18-*19.

As for wage orders, employees are arguably entitled to a limited priority under ' 507(a) of the Code anyway, with a showing that the debtor has sufficient ability to pay all of its priority claims. But wage claims limited by a dollar amount have only a third priority under ' 507(a), after administrative and other priority expenses. Even if the debtor has sufficient assets at the outset of the case to satisfy priority wage claims, this may not be true in a liquidation 2 years later.

Retail debtors usually obtain first day orders authorizing the honoring of customer deposits, gift certificates and returns. Customer deposits are entitled to a limited sixth priority (' 507(a)(6)), but there is no basis for going further. The same is true with payments to foreign creditors. These payments have become “necessary” only because courts have allowed them to be paid, and because employees or creditors have come to expect them.

Courts may interpret the provisions of the Code so as to give meaning to unclear statutory language. But they are not free to rewrite the Code. If more flexibility is needed in the payment of claims in reorganization cases, Congress should amend the Code.

Congress has, in fact, provided special status to certain prepetition creditors when it found a compelling reason. Pursuant to ' 546(c), a pre-petition creditor who has made a timely demand is entitled to reclaim its merchandise or be granted an administration claim. Under ' 546(g)*, the debtor, with court approval and with the consent of the creditor, may return goods for a credit against the creditors' pre-petition claim. Code ' 365(b)(1) also provides for payment of prepetition debt upon assumption of an executory contract. With respect to critical vendors, however, Congress could, if it chooses, also set forth specific requirements in order to eliminate abuse of the process.

The Code is a uniform federal statute. With different lower courts applying the Doctrine of Necessity differently, bankruptcy law has come to mean different things depending upon a particular judge's attitude. This is bad law and bad policy, as the Seventh Circuit stressed in Kmart.

at Hahn & Hessen, in the preparation of this article.

Last month, we explained that a bankruptcy court lacks “either the statutory or equitable power to authorize” the debtor's payment of pre-bankruptcy nonpriority unsecured claims, as noted in Capital Factors, Inc. v. Kmart Corp . ( In re Kmart Corp. ) We explained that the clear, no-nonsense opinions of the district court and the Court of Appeals reversed four bankruptcy court orders, and we explained why the Seventh Circuit's Kmart decision is noteworthy. We went on to discuss the “Doctrine of Necessity” (the Doctrine), a current justification used by some bankrtupcy courts to permit the post-petition payment of certain assertedly “essential” pre-petition claims in Chapter 11 reoganized cases.

This month, we discuss Principal Judicial Precedents, Decisions Favorable to the Doctrine, Cases Rejecting the Doctrine, and The Rebirth of the “Doctrine of Necessity.”

Principal Judicial Precedents

Most bankruptcy court orders applying the Doctrine are not appealed and are never published. Probable reasons for the failure of appellate review include the following: 1) strong probability of reorganization; 2) lack of resources; 3) payment coming from a secured creditor's collateral; and 4) the relatively small amount of the payment. Also, many first day orders are entered before creditors have organized, with little or no notice. See, e.g., Kmart, 2004 U.S. App. LEXIS 3397 at *1-*3.

Judicial rulings prior to Kmart fall into three camps: 1) those accepting the Doctrine; 2) those restricting application of the Doctrine; and 3) courts rejecting the Doctrine outright as a violation of the Code's priority and plan provisions.

Decisions Favorable to the Doctrine

The Doctrine is often associated with orders authorizing payment to “critical vendors,” but most of the published opinions favoring the Doctrine have been based on payment of employee benefits and wages. One district court upheld a bankruptcy court order empowering the debtors to pay prepetition wages, reimbursable expenses, health benefits, and the workers compensation claims of employees in some, but not all, states. In re Chateaugay Corp., 80 B.R. 279 (S.D.N.Y. 1987). The State of Michigan argued that this ruling discriminated within a class, in violation of Code ' 1122, and violated priority rules of Code ' 507. Relying on railroad cases and the bankruptcy court's equitable powers, the district court reasoned as follows:

A rigid application of the priorities of ' 507 would be inconsistent with the fundamental purpose of reorganization … [The] grant of equity powers to bankruptcy courts [was meant] to create a flexible mechanism that will permit the greatest likelihood of survival of the debtor and payment of creditors in full or at least proportionately. The Supreme Court has emphasized the special nature of reorganization [cases] …

Moreover, there is a serious question whether ' 507 applies at this stage of the bankruptcy [case] …

Also extending the reach and requirements of ' 1122 to preplan stages of the [case] would [be] inconsistent with the purpose of the [Code], limit the flexibility of the court and the debtor … '[T]he fact that bankruptcy courts are courts of equity … allows exceptions to any strict rules of classification of claims.' 80 B.R. at 287-88 (emphasis added) (citation omitted). This reasoning probably startled law professors and bankruptcy scholars at the time.

When Eastern Air Lines was authorized to pay prepetition wages, salaries, medical expenses and business expense claims of active employees, while denying the same payments to striking workers, In re Ionosphere Clubs, 98 B.R. 174 (Bankr. S.D.N.Y. 1989), the court found it “critical for [the debtor] to pay such pre-petition claims in order to preserve and protect its business and ultimately reorganize, retain its currently working employees and maintain positive employee morale.” Id. at 175 citing Dudley v. Mealey , 147 F.2d 268 (2d Cir. 1945), Code ' ' 105(a) and 363(b), and the Six Month Rule in the Railway Labor Act. The court also cited NLRB v. Bildisco & Bildisco , 465 U.S. 513 (1984), holding that “[t]he policy of equality among creditors … may be of significance in liquidation cases under Chapter 7, [but] the paramount policy and goal of Chapter 11, to which all other bankruptcy policies are subordinated, is the rehabilitation of the debtor.” I onosphere , 98 B.R. at 176.

In In re Sharon Steel Corp., 159 B.R. 730 (Bankr. W.D. Pa. 1993), the court denied, on grounds of lack of standing, a stay pending appeal from an order to permit the sale of the debtor's steel inventory, with a portion of the proceeds reserved for prepetition union employees' wage claims. Grounding its ruling on the “Necessity of Payment” doctrine, the court held that the agreement with its union was necessary because the union's picket line was “essentially paralyzing the Debtor's operations,” posing a serious threat to the Chapter 11 process. Id. at 734. The court pointed to flat or falling steel prices, the expense incurred in holding the goods, the legitimacy of the workers' complaints, their constitutional right to picket and the need to quell them. It also observed that the appellant's failure to suggest a viable alternative means of liquidating the inventory amounted to tacit approval of the order.

The underlying rationale in these employee wage cases was summarized in In re Gulf Air, Inc., 112 B.R. 152 (Bankr. W.D. La. 1989). Stating that airline cases are analogous to the railroad cases that spawned the “Necessity of Payment” doctrine, the court permitted all pre-petition wages, health and life insurance premiums, worker's compensation premiums, and incurred expenses of the debtor airline's employees to be paid because “without immediate payment, many of the Debtor's skilled employees will abandon their employment, and … immediate payment is essential to reorganization efforts … [T]he Court must act immediately to safeguard against the loss of the going-concern values.” Id. at 153. Accord In re Federated Dep't Stores, Inc., 1990 Bankr. LEXIS 122, *9-*10 (Bankr. S.D. Ohio Jan. 15, 1990) (authorized payment of 1) prepetition employee wages, salaries and benefits; 2) payments to concessionaire lessees; and 3) payments to customers for refunds and deposits; payments were authorized because “[t]he success of these cases hinges on the Debtor's [sic] ability to preserve their relationships with employees, customers and department lessees and, therefore, on Debtors' ability to pay pre-petition claims as requested in the Motions.”)

Unfavorable Rulings Recognizing the Doctrine

In a moderating opinion, the court in In re Structurelite Plastics Corp., 86 B.R. 922 (Bankr. S.D. Ohio 1988), reviewed conflicting judicial authority concerning the Doctrine and found a middle ground. It denied payment to a health care trust fund for reimbursement of employee prepetition expenses for catastrophic illness despite arguments that employee morale would suffer. Id. According to the court, “permitting a Chapter 11 debtor to selectively pay pre-petition indebtedness serves to create priorities among the general unsecured creditor body that are inconsistent with the distributive scheme envisioned by ' 507. On the other hand, a per se rule proscribing the payment of pre-petition indebtedness may well be too inflexible to permit the effectuation of the rehabilitative purposes of the Code.” Id. at 932. The court envisioned rare instances when prepetition claims could be paid if absolutely vital to the reorganization and if the payment would maximize the ultimate interest of all creditors. Id.

Conceding that the “Necessity of Payment” rule is an established narrow exception to ' 507, the court in In re NVR, L.P., 147 B.R. 126 (Bankr. E.D. Va. 1992), refused to authorize payment of a prepetition incentive bonus to a terminated employee who was earning a considerable postpetition income as an outside consultant. Finding that the rule is one of necessity and not convenience, the court stated that “[u]nder 11 U.S.C. ' 105(a) the court can permit the pre-plan payment of a pre-petition obligation when essential to the continued operation of the debtor. However, ' 105 may not be used as a vehicle to discriminate among priority claims when there is no compelling business need for such discrimination.” Id. at 127 (citation omitted).

Cases Rejecting the Doctrine

Still other courts have rejected the Doctrine outright. In The Official Committee of Equity Security Holders v. Mabey (In re A.H. Robins Co.), 832 F.2d 299 (4th Cir. 1987), the Fourth Circuit reversed the district court's authorization for interim pre-plan payments to victims of the Dalkon Shield IUD for reconstructive surgery or for in vitro fertilization. The court explained that Code ' 105(a) did not furnish authority for an emergency treatment fund; that all distributions must be made only to approved claimants (the amounts of the claims were still being contested) through a confirmed plan; and that it was antithetical to the Code to prefer one unsecured creditor (requiring surgery or fertilization) over another (those not requiring medical intervention). Id. As the court stated, “[t]he creation of the [fund] has no authority to support it in the Bankruptcy Code and violates the clear policy of Chapter 11 reorganizations by allowing piecemeal, pre-confirmation payments to certain unsecured creditors.” Id. at 302.

In In re Revco D.S., Inc., 91 B.R. 777 (Bankr. N. D. Ohio 1988), the court denied the debtor authorization to pay prepetition trust fund taxes. The debtor's officers were personally threatened with liability for the arrearage, and the debtors argued that this threat was demoralizing to the company. The debtor also stressed that the tax liability was a priority claim that would have to be paid in a confirmed reorganization plan. Rejecting the debtor's arguments, the court ruled that equality of all unsecured creditors and payment only under a plan were mandatory under the Code. It added that ' 507(a)(7) afforded no greater priority to the trust fund taxes than to other taxes, and that permitting the debtor to cave into threats would supply taxing authorities with a reliable means of bypassing established bankruptcy procedures. See In re FCX, Inc., 60 B.R. 405 (E.D.N.C. 1986), (district court, when reversing bankruptcy court's order authorizing payment of prepetition claims to employees and grain producers, rejected argument that all unsecured creditors were expected to be paid, nor did court accept argument that going concern value of debtor would be lost if requested payments were not made; even in emergency situations, absent express authorization by Code, ' 507 priorities must be followed; despite bankruptcy court's equitable powers, “[t]he court cannot use this flexibility … merely to establish a ranking of priorities within priorities … [A]bsent the existence of some type of inequitable conduct … the court cannot subordinate a claim to claims within the same class.”).

The Rebirth of the 'Doctrine of Necessity'

The Doctrine of Necessity, justifying payment of “critical vendors,” has resurfaced in reorganization cases over the last 10 years. Debtors routinely sought critical vendor protection for favored domestic vendors who were their major suppliers. In the preceding 90 years, though, debtors found ways to pacify major suppliers and thus maintain an adequate supply of inventory. Debtors and their counsel now decided that it would be easier to pay their major suppliers. As a result, major suppliers began to insist on “critical vendor” status at the outset of the case.

Debtors and their ingenious counsel then went further. They sought to pay unnamed critical vendors up to a dollar limitation (ie, the amount to which their lenders would agree). One became a critical vendor by simply agreeing to provide unsecured credit to the debtor up to the amount of the pre-petition payment. This was, in fact, “a condition of payment for pre-petition debts” in Kmart 2004 U.S. App. LEXIS 3397 at *6. Although there is arguably some risk in extending credit to a Chapter 11 debtor, converting a pre-petition unsecured claim into a Chapter 11 administrative claim became highly attractive. The Doctrine thus became a gimmick for debtors to obtain post-petition credit.

The Doctrine Lacks a Basis in the Code

One can dress up payments to prepetition creditors with ' 105(a) or any other section of the Code, but “still the emperor has no clothes.” Section 105(a) authorizes the court to issue “any order … that is necessary or appropriate to carry out the provisions of this title.” But no provisions in the Code have to be carried out by using the Doctrine, as the Seventh Circuit stressed in Kmart:

This does not create discretion to set aside the Code's rules about priority and distribution; the power conferred by ' 105(a) is one to implement rather than override. See Norwest Bank Worthington v. Ahlers , 485 U.S. 197, 206, 99 L. Ed. 2d 169, 108 S. Ct. 963 (1988); In re Fesco Plastics Corp., 996 F.2d 152, 154 (7th Cir. 1993). Cf. United States v. Noland , 517 U.S. 535, 542, 134 L. Ed. 2d 748, 116 S. Ct. 1524 (1996). Every circuit that has considered the question has held that this statute does not allow a bankruptcy judge to authorize full payment of any unsecured debt, unless all unsecured creditors in the class are paid in full. See In re Oxford Management, Inc., 4 F.3d 1329 (5th Cir. 1993); Official Committee of Equity Security Holders v. Mabey 832 F.2d 299 (4th Cir. 1987); In re B&W Enterprises, Inc., 713 F.2d 534 (9th Cir. 1983). We agree with this view of ' 105. 'The fact that a [bankruptcy case] is equitable does not give the judge a free-floating discretion to redistribute rights in accordance with his personal views of justice and fairness, however enlightened those views may be.' In re Chicago, Milwaukee, St. Paul & Pacific R.R., 791 F.2d 524, 528 (7th Cir. 1986).

2004 U.S. App. LEXIS 3397 at *10-*11. This reasoning applies to critical vendor orders and beyond.

There may be equitable reasons why critical payments must be made. Courts may understandably try to save a business during the early stages of a reorganization. Nobody can predict whether a business can or will be reorganized. See generally, Eisenberg R, Gecker F: The Doctrine of Necessity and Its Parameters, 73 Marq. L. Rev. 1 (1989) (“Creditors realize that it is in their best interests to permit certain prepetition creditors to be paid immediately, for if those creditors are not paid at once, everyone will suffer.”); Festerson: Equitable Powers in Bankruptcy Rehabilitation: Protection of the Debtor and the Doomsday Principle, 46 Am. Bankr. L.J. 311, 317 (1972) (when strict construction of governing statute may force deserving debtor to brink of disaster, courts have frequently found creative solutions; the greater the crisis, the more likely that courts will use equitable power to grant pragmatic relief). In Kmart, however, the debtor failed even to make the proper record:

The court did not find that any firm would have ceased doing business with Kmart if not paid for pre-petition deliveries, and the scant record would not have supported such a finding had one been made. The court did not find that discrimination among unsecured creditors was the only way to facilitate a reorganization. It did not find that the disfavored creditors were at least as well off as they would have been had the critical-vendors order not been entered …

Even if ' 36[3](b)(1) allows critical vendors orders in principle, preferential payments to a class of creditors are proper only if the record shows the prospect of benefit to the other creditors. This record does not, so the critical vendors order cannot stand.

2004 U.S. App. LEXIS 3397 at *18-*19.

As for wage orders, employees are arguably entitled to a limited priority under ' 507(a) of the Code anyway, with a showing that the debtor has sufficient ability to pay all of its priority claims. But wage claims limited by a dollar amount have only a third priority under ' 507(a), after administrative and other priority expenses. Even if the debtor has sufficient assets at the outset of the case to satisfy priority wage claims, this may not be true in a liquidation 2 years later.

Retail debtors usually obtain first day orders authorizing the honoring of customer deposits, gift certificates and returns. Customer deposits are entitled to a limited sixth priority (' 507(a)(6)), but there is no basis for going further. The same is true with payments to foreign creditors. These payments have become “necessary” only because courts have allowed them to be paid, and because employees or creditors have come to expect them.

Courts may interpret the provisions of the Code so as to give meaning to unclear statutory language. But they are not free to rewrite the Code. If more flexibility is needed in the payment of claims in reorganization cases, Congress should amend the Code.

Congress has, in fact, provided special status to certain prepetition creditors when it found a compelling reason. Pursuant to ' 546(c), a pre-petition creditor who has made a timely demand is entitled to reclaim its merchandise or be granted an administration claim. Under ' 546(g)*, the debtor, with court approval and with the consent of the creditor, may return goods for a credit against the creditors' pre-petition claim. Code ' 365(b)(1) also provides for payment of prepetition debt upon assumption of an executory contract. With respect to critical vendors, however, Congress could, if it chooses, also set forth specific requirements in order to eliminate abuse of the process.

The Code is a uniform federal statute. With different lower courts applying the Doctrine of Necessity differently, bankruptcy law has come to mean different things depending upon a particular judge's attitude. This is bad law and bad policy, as the Seventh Circuit stressed in Kmart.

at Hahn & Hessen, in the preparation of this article.