April/May 2003

Payment of Crucial Vendors Under the Doctrine of Necessity

By Baxter Dunaway

On January 22, 2002, Kmart Corporation and certain of its domestic subsidiaries and affiliates, debtors and debtors-in-possession filed a voluntary petition for reorganization pursuant to chapter 11 of the United States Bankruptcy Code. As part of its "first day motions" filed on that date, Kmart sought authority to pay $327 million prepetition obligations to certain "critical vendors" and certain foreign vendors. Kmart contended that these payments were necessary to maintain relationships essential to its continued operation and reorganization, and it invoked the "doctrine of necessity" and 11 U.S.C. § 105(a) for the bankruptcy court's authority to permit these payments. The doctrine is not codified anywhere in the Bankruptcy Code, so the only way to apply it is through § 105. On February 13, 2002 the bankruptcy court held a hearing on these motions, heard evidence, and granted both motions over objections. On April 1, 2003, the District Court reversed. Capital Factors, Inc. v. Kmart Corporation. The Kmart case is discussed below. This case raises the “Doctrine of Necessity” or “Necessity of Payment Rule”. See 2 William L. Norton, Jr., Norton Bankr.L. & Prac.2d § 42:11 (Supp.2002); Russell A. Eisenberg & Frances F. Gecker, The Doctrine of Necessity and Its Parameters, 73 Marq. L.Rev. 1, 6 (1989) for a discussion of the doctrine's history.

Doctrine of Necessity
There is a split in the courts regarding whether § 105 authorizes bankruptcy courts to permit pre-plan payment of prepe-tition unsecured claims under the the “Doctrine of Necessity” or “Necessity of Payment Rule”. Many bankruptcy courts and a handful of district courts have held that bankruptcy courts do in fact have this power. See, e.g., In re Just For Feet, Inc., 242 B.R. 821 (D.Del.1999); Michigan Bureau of Workers' Disability Comp. v. Chateaugay Corp. (In re Chateaugay Corp .), 80 B.R. 279 (S.D.N.Y.1987); In re CoServ, L.L.C., 273 B.R. 487 (Bankr.N.D.Tex.2002); In re Wehrenberg. Inc., 260 B.R. 468 (Bankr.E.D.Mo.2001). On the other hand, a number of courts of appeals and a few lower courts have held just the opposite. See, e .g., Official Comm. of Equity Sec. Holders v. Mabey, 832 F.2d 299 (4th Cir.1987); B & W Enters., Inc. v. Goodman Oil Co. (In re B & W Enters., Inc.), 713 F.2d 534 (9th Cir.1983); Chiasson v. J. Louis Matherne & Assocs. (In re Oxford Mgmt. Inc.), 4 F.3d 1329 (5th Cir.1993); In re FCX. Inc., 60 B.R. 405 (E.D.N.C.1986); In re Timberhouse Post & Beam, Ltd., 196 B.R. 547 (Bankr.D.Mont.1996).

The Necessity of Payment Rule is a rule of payment not of priority. See In re Boston & Maine Corp., 468 F.Supp. 996, 1008 (D.Mass.1979). This Rule developed to allow trustees to pay prepetition debts under threats of creditors in order to obtain continued supplies or services essential to the continued operation of the debtor's business. See In re B & W Enter., Inc., 713 F.2d at 537. The early line of cases dealing with this Rule were limited to railroad reorganizations, and empha-sized that, if no threat to the continued operation of the railroad was implicated, the Rule was inapplicable. See In re Boston & Maine Corp., 468 F.Supp. at 1008.

The Rule has occasionally been extended to non-railroad debtors. See Dudley v. Mealey, 147 F.2d 268 (2d Cir.1945); other courts declined to extend the Rule to non-railroad cases. See, e.g., In re B & W Enter., Inc., 713 F.2d at 537); In re Ionosphere Clubs, Inc., 98 B.R. 174 (Bankr.S.D.N.Y.1989). In Ionosphere, the court relied on the Rule to authorize the payment of active employees' prepetition wages, salary and benefit claims. The court analogized the case before it (that of Eastern Airlines) to the railway cases. See In re Ionosphere Clubs, 98 B.R. at 176. These cases emphasized that the Rule was applicable to further a paramount consideration of chapter 11, that of continued operation and rehabilitation of the debtor. See id. It is this line of case law that requires the "debtor to show that payment of the pre-petition claims is 'critical to the debtor's reorganization.' " See In re Just for Feet, Inc., 242 B.R. at 826 (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 Indus., Inc., 124 B.R. 1021, 1023 (Bankr.S.D.Ohio 1991)).

In the extension of the Necessity of Payment Rule to non-railroad debtors, the Doctrine was born and the Rule became known as the "Doctrine of Necessity." As later cases arose, courts often used the terms "Doctrine of Necessity" and "Necessity of Payment Rule" interchangeably.

Capital Factors, Inc. v. Kmart Corporation

In January, 2002 Kmart filed for bankruptcy protection struggling to compete in a sector dominated by Wal-Mart Stores Inc. and Target Corp. According to the court documents, the biggest percentage of votes to reject Kmart's plan of reorganization came from a group owed money from supply deals or leases. That group had claims against Kmart totalling just under $3.9 billion . Creditors representing a quarter of that amount voted to reject the plan. Kmart alleged it could not stay in business without the good will of the vendors. Bankruptcy Court Judge Sonderby allowed Kmart to pay $327 million in pre-bankruptcy debt to “critical vendors”.

In Capital Factors, Inc. v. Kmart Corporation, — B.R. —, 2003 WL 1868753 (N.D. Ill. 2003) the District Court re-versed the Bankruptcy Court granting of the motions to pay the prepetition creditors. The District Court ruling is being appealed to the U.S. 7th Circuit Court of Appeals.

The District Court examined the question of whether the bankruptcy court had the power to authorize the pre-plan pay-ment of prepetition claims. The Bankruptcy Court relied on 11 U.S.C. § 105(a) to authorize the payments. Section 105(a) addresses the equitable powers of bankruptcy courts and 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 process. 11 U.S.C. § 105(a).

In reversing, the District Court noted that the grant of equitable power in § 105 is limited in that it "allows [bankruptcy] courts to use their equitable powers only as necessary to enforce the provisions of the Code, not to add on to the Code as they see fit." In re Fesco Plastics Corp., 996 F.2d 152, 156 (7th Cir.1993); see also Gouveia v. Tazbir, 37 F.3d 295, 300 (7th Cir.1994) ("The Supreme Court has taught that any grant of authority given to the bankruptcy courts under § 105 must be exercised within the confines of the bankruptcy code.") (citing Norwest Bank Worthington v. Ahlers, 485 U.S. 197 (1988)). In rejecting the granting of the payment to critical vendors, the Court stated:

We acknowledge that the application of the "doctrine of necessity" through § 105 in this situation is well-intended and may even have some beneficial results, in that pre-plan payment of certain prepetition claims allows the debtor to minimize disruptions in doing business, and thus may further reorganization. Nevertheless, it is clear that however useful and practical these 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. 2003 WL 1868753, *3.

After the District Court decision, the Bankruptcy Court Judge Sonderby turned down pleas from trade creditors who had requested a delay in view of the District Court decision. Judge Sonderby stated she did not want to jeopardize the confirmation process. The plan envisions paying back holders of secured credit such as mortgages 100 cents on the dollar in cash but that amount is expected to be reinvested. Banks holding $1.076 billion in pre-bankruptcy debt would get 40 cents on the dollar also in cash. Holders of $2.27 billion in bonds would get 14.4 percent of theirclaims in newly issued Kmart stock. Trade-vendor claims, such as that of Capital Factors, would get 9.7 percent in the newly issued stock.

After negotiations and agreements, the plan was approved. The company's largest shareholder now will be ESL In-vestments, a $5 billion hedge fund that invests in retailers. ESL, which will own 49 percent of Kmart, is converting $2 billion in claims into stock and offering $109 million cash for operations. One of the biggest obstacles to the court's approval was removed when Capital Factors Inc. - which held $20 million in unsecured Kmart debt - reached a deal in which Kmart is to make various concessions and ESL is to buy an unspecified part of the debt.