'Necessity' Revisited: Wishing Won't Make It So

“Yet what these decisions principally say is that priorities do not change unless a statute supports that step; and if ' 363(b)(1) is such a statute, then there is no insuperable problem. If the language is too open-ended, that is a problem for the legislature. Nonetheless, it is prudent to read, and use, ' 363(b)(1) to do the least damage possible to priorities established by contract and by other parts of the Bankruptcy Code. We need not decide whether ' 363(b)(1) could support payment of some pre-petition debts, because this order was unsound no matter how one reads ' 363(b)(1).” 359 F. 3d at 872

Similarly, in a passage actually cited by Cook and Fabrizio in The Bankruptcy Strategist, May 2004, p. 7, the court goes on to say at p. 874:

“Even if ' 362(b)(1) [Obviously should read 363(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.

What Is Left of the Necessity Doctrine?

What then is left of the Necessity Doctrine in the Seventh Circuit? Ideally, there should be little or nothing (Except as to those orders – including four in Kmart – from which timely appeals were never taken. This author is currently representing a litigant asserting rights under one of those unappealed Kmart orders). As Cook and Fabrizio correctly point out (Id., p. 6):

“The Doctrine of Necessity … has resurfaced in reorganization cases over the last 10 years … In the preceding 90 years, though, debtors found ways to pacify major suppliers and thus maintain an adequate supply of inventory. “

As those of us who practiced during that 90-year period are aware, an essential element of that “pacification” was the advice given to both debtors and creditors by their respective attorneys that courts simply would not permit the type of favored treatment which has become commonplace in certain jurisdictions since the early 90's. Moreover most debtors, and certainly their attorneys and accountants, recognize that the ability to freeze all general unsecured debt on the petition date will inevitably enhance the liquidity and cash flow of the struggling enterprise at the time when it “critically” needs that enhancement.

Where We Stand Now

So, where do we stand now? Certainly “critical vendor” orders will no longer be granted ex parte on a general finding that they will serve “the best interest of the Debtors, their estates and their creditors.” Cf. 359 F 3d at 868-9. Nor is it likely that any court in the Seventh Circuit will grant “open-handed permission” or “unilateral discretion” to the Debtor to decide which creditors, if any shall be selected for favored treatment. Id. As a minimum, the evidence must establish, and the Bankruptcy Court must specifically find:

“… not only that the disfavored creditors will be as well of with reorganization as with liquidation … .but that the supposedly critical vendors would have ceased deliveries if old debts were left unpaid.” Id. at 873.

The Opinion also strongly suggests that the court must find that no measure short of favored treatment of one or more general unsecured creditors will enable the enterprise to survive. At pages 873-874, after describing some of the alternatives available to the Kmart case, it goes on to say:

“Yet the bankruptcy court did not explore the possibility of using a letter of credit to assure vendors of payment. 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. “

Finally, the Opinion implies most strongly that there must be meaningful representation of “disfavored” creditors at any hearing of a “critical vendor” motion. Not only is this inherent in the court's insistence that these creditors suffer no prejudice, but also in the following tongue-in-cheek comment made at page 870:

“As a rule, a trustee or debtor in possession represents the interests of many stakeholders. Kmart vigorously represented the interests of Handleman and the other vendors Kmart deemed 'critical.'”

Conclusion

Let us hope that in the not-too-distant future the Seventh Circuit is faced squarely with the question of whether Section 363 or any other Section of the Code confers any authority whatsoever to “rearrange priorities among creditors … even though the Supreme Court has cautioned against such a step.” Cf. 359 F. 3d at 872. The experience of courts and practitioners during the 90-year period accurately described by Cook and Fabrizio (See page 2, supra) — to say nothing of the “plain language” rule — should persuade the Circuit to heed that caution (A corollary to the plain language rule is that “when two provisions in a statute are in conflict, 'a specific [provision] closely applicable to the substance of the controversy at hand controls over a more generalized provision.'” See Trak Auto Corp. v. West Town Center LLC, 367 F. 3d 237, 239, 243-44 (4th Cir. 2004) which is reviewed at page 8 of the June Issue of The Bankruptcy Strategist).

The April and May issues of The Bankruptcy Strategist featured a scholarly, interesting, and informative article by Michael L. Cook and William R. Fabrizio on the recent Seventh Circuit Kmart Opinion ( In Re Kmart Corporation , 359 F. 3d 866 (7 Cir. 2004)) in which the Circuit Court affirmed the District Court's reversal ( Capital Factors, Inc. v. Kmart Corporation , 291 B. R. 818 (ND Ill. 2003)) of four “critical vendor” orders entered by the Bankruptcy Judge. In all respects but one, Cook and Fabrizio concisely and accurately analyzed the Opinion as well as the history and basic flaws of the so-called “Necessity” Doctrine. Moreover, we agree not only with their conclusion that “the [Necessity] Doctrine … lacks explicit Code authorization,” but also with their flat rejection of such erroneous (and insulting) comments as that of the unnamed practitioner who was quoted by Reuters as stating that the District Court Opinion was “[A] tremendous blow to the efforts of the Chicago bench and bar to fashion their bankruptcy court system in the mold of Delaware and New York.” The Bankruptcy Strategist, April 2004, p. 2.

Overstating the Case

Unfortunately when they come to the Opinion of the Court of Appeals, Cook and Fabrizio overstate the case. Unlike the District Judge, the Seventh Circuit did not find a complete lack of “'statutory or equitable power to authorize' … payment of pre-bankruptcy non-priority unsecured claims.” Id., p. 1. Nor did the Circuit Court “virtually demolis[h]” the doctrine that the necessary authority may be found in Section 363 (b) of the Code itself. Id., p. 7. On the contrary, the court was very careful to avoid making — or even predicting — any decision as to the efficacy of Section 363(b), saying:

“Yet what these decisions principally say is that priorities do not change unless a statute supports that step; and if ' 363(b)(1) is such a statute, then there is no insuperable problem. If the language is too open-ended, that is a problem for the legislature. Nonetheless, it is prudent to read, and use, ' 363(b)(1) to do the least damage possible to priorities established by contract and by other parts of the Bankruptcy Code. We need not decide whether ' 363(b)(1) could support payment of some pre-petition debts, because this order was unsound no matter how one reads ' 363(b)(1).” 359 F. 3d at 872

Similarly, in a passage actually cited by Cook and Fabrizio in The Bankruptcy Strategist, May 2004, p. 7, the court goes on to say at p. 874:

“Even if ' 362(b)(1) [Obviously should read 363(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.

What Is Left of the Necessity Doctrine?

What then is left of the Necessity Doctrine in the Seventh Circuit? Ideally, there should be little or nothing (Except as to those orders – including four in Kmart – from which timely appeals were never taken. This author is currently representing a litigant asserting rights under one of those unappealed Kmart orders). As Cook and Fabrizio correctly point out (Id., p. 6):

“The Doctrine of Necessity … has resurfaced in reorganization cases over the last 10 years … In the preceding 90 years, though, debtors found ways to pacify major suppliers and thus maintain an adequate supply of inventory. “

As those of us who practiced during that 90-year period are aware, an essential element of that “pacification” was the advice given to both debtors and creditors by their respective attorneys that courts simply would not permit the type of favored treatment which has become commonplace in certain jurisdictions since the early 90's. Moreover most debtors, and certainly their attorneys and accountants, recognize that the ability to freeze all general unsecured debt on the petition date will inevitably enhance the liquidity and cash flow of the struggling enterprise at the time when it “critically” needs that enhancement.

Where We Stand Now

So, where do we stand now? Certainly “critical vendor” orders will no longer be granted ex parte on a general finding that they will serve “the best interest of the Debtors, their estates and their creditors.” Cf. 359 F 3d at 868-9. Nor is it likely that any court in the Seventh Circuit will grant “open-handed permission” or “unilateral discretion” to the Debtor to decide which creditors, if any shall be selected for favored treatment. Id. As a minimum, the evidence must establish, and the Bankruptcy Court must specifically find:

“… not only that the disfavored creditors will be as well of with reorganization as with liquidation … .but that the supposedly critical vendors would have ceased deliveries if old debts were left unpaid.” Id. at 873.

The Opinion also strongly suggests that the court must find that no measure short of favored treatment of one or more general unsecured creditors will enable the enterprise to survive. At pages 873-874, after describing some of the alternatives available to the Kmart case, it goes on to say:

“Yet the bankruptcy court did not explore the possibility of using a letter of credit to assure vendors of payment. 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. “

Finally, the Opinion implies most strongly that there must be meaningful representation of “disfavored” creditors at any hearing of a “critical vendor” motion. Not only is this inherent in the court's insistence that these creditors suffer no prejudice, but also in the following tongue-in-cheek comment made at page 870:

“As a rule, a trustee or debtor in possession represents the interests of many stakeholders. Kmart vigorously represented the interests of Handleman and the other vendors Kmart deemed 'critical.'”

Conclusion

Let us hope that in the not-too-distant future the Seventh Circuit is faced squarely with the question of whether Section 363 or any other Section of the Code confers any authority whatsoever to “rearrange priorities among creditors … even though the Supreme Court has cautioned against such a step.” Cf. 359 F. 3d at 872. The experience of courts and practitioners during the 90-year period accurately described by Cook and Fabrizio ( See page 2, supra ) — to say nothing of the “plain language” rule — should persuade the Circuit to heed that caution (A corollary to the plain language rule is that “when two provisions in a statute are in conflict, 'a specific [provision] closely applicable to the substance of the controversy at hand controls over a more generalized provision.'” See Trak Auto Corp. v. West Town Center LLC , 367 F. 3d 237, 239, 243-44 (4th Cir. 2004) which is reviewed at page 8 of the June Issue of The Bankruptcy Strategist ).