Seventh Circuit Deals Blow to Critical Vendor Doctrine
 
March 29, 2004
 
Stephen A. "Steve" Bogorad- Washington

On February 24, 2004, the United States Court of Appeals for the Seventh Circuit issued a decision in an appeal arising out of the Kmart Corporation (Kmart) bankruptcy that may dramatically affect large and small business bankruptcy cases across the country.[1] The Seventh Circuit affirmed a United States District Court’s reversal of an order by the Bankruptcy Court in the Kmart bankruptcy case that had granted the debtor authority to pay in full prepetition claims of any vendor the debtor deemed critical, provided that such “critical vendor” agreed to furnish goods on “customary trade terms.”[2]

The debtor paid 2,330 suppliers (the so called “critical vendors) a total of approximately $300 million in satisfaction of prepetition debts pursuant to the Bankruptcy Court’s order, while approximately 2,000 other vendors, who were not deemed “critical” by the debtor, were not paid. As a result of the Seventh Circuit’s decision, Kmart is now sending letters to the vendors whose prepetition claims were paid in full, asking them to return the payments, and the debtor will have to sue those vendors who refuse to voluntarily return the payments.

The “critical vendor” doctrine, which is routinely applied in large and small business bankruptcy cases across the country, is cited by a debtor that wishes to pay prepetition debts owed to vendors that the debtor deems to be critical to the debtors ongoing business, on the theory that such vendors would refuse to do business with the debtor post-petition unless their prepetition claims are paid in full, jeopardizing the debtor’s ability to reorganize. The application of the critical vendor doctrine results in the critical vendors jumping ahead in payment priority over the other unsecured prepetition creditors, who often receive only pennies on the dollar (and sometimes nothing) on their prepetition claims.

The Seventh Circuit’s Kmart decision deals two blows to the critical vendor doctrine. First, the Kmart decision calls into question the continued vitality of the critical vendor doctrine under any circumstances. While the Seventh Circuit did not affirmatively rule that the Bankruptcy Code prohibits preferential payments of prepetition claims of so called critical vendors, the decision strongly suggests that the Seventh Circuit, or at least this particular panel of the Seventh Circuit, might eventually rule that there can be no preferential treatment of critical vendors under the Bankruptcy Code. Second, the Kmart decision imposes a high burden of proof for a debtor to invoke the critical vendor doctrine, assuming that payment of prepetition debts owed to critical vendors is ever permissible under the Bankruptcy Code. This article addresses both aspects of the Seventh Circuit’s ruling.

Higher Burden of Proof Imposed On Debtor

Kmart sought permission to pay immediately, and in full, the prepetition claims of all vendors that the debtor deemed to be critical. The debtor did not identify specific vendors that it sought permission to pay (as debtors often do in critical vendor motions), but instead sought an order that would grant the debtor discretion to determine which vendors were “critical.” As articulated by the Seventh Circuit, the theory behind the critical vendor doctrine is that some suppliers will refuse to do business with a debtor if their prepetition claims are not paid in full, and that if the debtor cannot obtain certain merchandise that its customers are accustomed to purchasing, a debtor such as Kmart may be unable to carry on its business. Full payment to the preferred critical vendors could therefore, in principle, benefit even the disfavored prepetition creditors whose claims are not paid, since they may eventually receive a higher pay-off on their claims than they would have received if the debtor was forced to shut down its business.

The Seventh Circuit found that the Bankruptcy Court granted the critical vendor motion without receiving any pertinent evidence that the critical vendors would refuse to ship goods to the debtor post-petition absent payment in full of their prepetition claims, and that the Bankruptcy Court’s decision was based only on “some sketchy representations by counsel plus unhelpful testimony by Kmart’s CEO, who could not speak for the vendors,” and on the Bankruptcy Court’s general finding that the granting of the motion “was in the best interests of the Debtor, their estates and their creditors.” The Seventh Circuit criticized the Bankruptcy Court for failing to make a finding of fact that the disfavored creditors would gain or come out even as a result of the granting of the critical vendor motion, and noted that the record would not have supported such a finding.

While the Seventh Circuit came close to holding that preferred payments of pre-petition claims of certain critical vendors may never be permissible under the Bankruptcy Code, the Kmart Court stopped short of determining that issue, based on a finding that even if such payments are permissible under certain conditions, Kmart did not meet the necessary burden of proof to justify such payments. The Seventh Circuit held that for critical vendor payments to be permissible, the debtor must prove (i) that disfavored creditors will be as well off with a reorganization facilitated by critical vendor payments as in a liquidation proceeding; and (ii) that the supposedly critical vendors would have ceased deliveries if prepetition debts were left unpaid.

The first requirement imposed by the Seventh Circuit, that the debtor prove that prepetition creditors who are not critical vendors will be as well off with a reorganization facilitated by critical vendor payments as they would be in a liquidation, is quite daunting. Critical vendor motions are usually filed as “first day motions,” presented to the Court on the first or second day of a Chapter 11 case, at a time when the debtor often has no idea what the debtor’s plan of reorganization may entail, and how the plan will treat various classes of creditors. In a case such as Kmart, in which the debtor is proposing to pay in full more than half of the prepetition claims of its vendors, while leaving a lesser number to await treatment under a plan, it may be very difficult to show that the disfavored creditors will fare as well, or better, under a plan that the debtor has not yet begun to formulate, than such creditor would fare under a liquidation proceeding, in which millions of dollars are not paid to critical vendors on a preferred basis, remaining available, instead, for payment to all unsecured creditors on a pro rata basis. Meeting such a burden would likely require a fairly lengthy evidentiary presentation, including expert testimony. This is a far cry from the “showing” typically made by debtors in support of a critical vendor motion — that the payments are necessary for the debtor to continue its business operations.

The second requirement imposed by the Seventh Circuit, that the debtor prove that the supposedly critical vendors will cease deliveries if old debts are left unpaid, may also be a difficult burden to meet. The Seventh Circuit noted that some supposedly critical vendors, including Fleming Companies (the vendor that received the largest critical vendor payment from Kmart), would have to continue to do business with debtors even if their prepetition claims were not paid because those vendors have contracts with the debtors requiring them to do so, and the automatic stay would prohibit the vendors from refusing to do business with the debtor based on the debtor’s failure to pay prepetition debts. The Seventh Circuit also noted that many other so-called critical vendors would be willing to do business with a debtor even if old bills are not paid because the vendors will make a profit on each post-petition transaction, as long as the vendors are assured that they will be paid for their post-petition transactions with the debtor. The Court noted that “firms that disdain current profits because of old losses are unlikely to stay in business.”

Although the Seventh Circuit acknowledged that many suppliers would fear the prospect of throwing good money after bad by continuing to do business with debtors who had failed to pay them for prepetition deliveries, the Court stated that such fears could likely be overcome by providing adequate assurance that post-petition deliveries would be paid for in full. The Court suggested two alternatives for providing such adequate assurance which would not involve payment for prepetition transactions – (i) payment of cash on delivery; or (ii) posting a standby letter of credit as collateral for payment of post-petition obligations – and noted that if lenders are unwilling to issue such letters of credit or if lenders insist on a letter of credit of short duration, “that would be a compelling market signal that reorganization is a poor prospect and that the debtor should be liquidated post haste.”

In affirming the reversal of the Bankruptcy Court’s critical vendor order, the Seventh Circuit criticized the Bankruptcy Court for granting the order without (i) exploring the possible use of a letter of credit to assure vendors of payment for post-petition transactions; (ii) making findings that any firm would cease doing business with the debtor if not paid for prepetition deliveries, (iii) making a finding that discrimination among unsecured creditors was the only way to facilitate a reorganization, and (iv) finding that disfavored creditors were at least as well off as they would have been had the critical vendor order not been issued.

Within the Seventh Circuit where this decision is binding precedent (which includes Chicago), the Kmart decision will make it much more difficult for debtors to obtain court approval of critical vendor orders. Debtors will need to come to court prepared to make a substantial evidentiary showing that particular vendors will refuse to do business with the debtor absent payment of their prepetition claims, despite the debtor’s attempt to use alternative means of assuring the vendors that post-petition transactions will be timely paid. It is unclear whether testimony from the debtor will be sufficient to meet this burden, or if debtors will need to provide testimony from at least some of the critical vendors at issue. At the very least, debtors will need to demonstrate that the critical vendors have actually advised the debtor that they will stop doing business with them absent payment of prepetition claims. Creditors opposing critical vendor orders should now be able to insist that they have an opportunity to depose at least a sampling of the critical vendors to probe whether, in fact, the vendors would be willing to do business with adequate assurance of payment, such as a letter of credit or COD terms, and whether the vendors are subject to executory contracts that prohibit them from refusing to do business with the debtor.

The result of this heightened burden on debtors will likely be that debtors, for whom a critical vendor order is important, who are otherwise inclined to file their Chapter 11 cases in Chicago and other courts within the Seventh Circuit, may now choose to file their cases in other jurisdictions. However, the impact of the Kmart decision may well extend beyond the Seventh Circuit. The decision by the Seventh Circuit is a very thoughtful, well-reasoned decision, that will be cited by creditors opposing critical vendor orders throughout the county. It will undoubtedly result in increased objections to such orders by disfavored prepetition creditors elsewhere, and is likely to be followed by some courts outside of the Seventh Circuit.

Viability of the Critical Vendor Doctrine

While the heightened burden of proof imposed by the Kmart decision will probably have the most immediate impact on future Chapter 11 cases, both within and outside of the Seventh Circuit, the Court’s analysis of the continued viability of the critical vendor doctrine could potentially have a far greater impact. Although the Court stops short of addressing the question of whether critical vendor orders are ever permissible under the Bankruptcy Code, the Court squarely rejects many of the arguments typically advanced by debtors in support of critical vendor orders, and leaves open the possibility that the Seventh Circuit may eventually rule that there can be no preferential payments to critical vendors under the Bankruptcy Code under any circumstances.

First, the Court addresses Section 105(a) of the Bankruptcy Code, which allows a bankruptcy court to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of” the Code. The Court held that Section 105(a) did “not create discretion to set aside the Code’s rules about priority and distribution,” and that “[t]he fact that a bankruptcy [proceeding] 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 rejecting the doctrine of necessity as a basis for critical vendor orders, the Court stated:

[a] “doctrine of necessity” is a just a fancy name for a power to depart from the [Bankruptcy] Code. Although courts in the days before bankruptcy law was codified wielded power to reorder priorities and pay particular creditors in the name of “necessity” ... today it is the [Bankruptcy] Code rather than the norms of nineteenth century railroad reorganizations that must prevail. ... Today the Bankruptcy Code of 1978 supplies the rules. Congress did not in terms scuttle old common-law doctrines, because it did not need to; the [Bankruptcy] Act curtailed, and then the [Bankruptcy] Code replaced, the entire apparatus. ... Older doctrines may survive as glosses on ambiguous language enacted in 1978 or later, but not as freestanding entitlement to trump the text.

The Seventh Circuit similarly rejected the arguments that Sections 364(b) (authorizing a debtor to obtain credit) and 503 (dealing with administrative expenses) of the Bankruptcy Code might be sources for authority to make preferential payments on pre-petition debts owed to critical vendors and, by the end of its analysis, concluded that there was only one potential Bankruptcy Code provision that might authorize a Bankruptcy Court to enter a critical vendor order.

– Section 363(b)(1). Section 363(b)(1) provides that a debtor “after notice and a hearing, may use, sell or lease, other than in the ordinary course of business, property of the estate.” The Kmart Court found that section 363(b)(1) might be read to authorize the entry of a critical vendor payment order because “satisfaction of a pre-petition debt in order to keep ‘critical’ supplies flowing is a use of property other than in the ordinary course of administering an estate in bankruptcy.” However, the Kmart Court found that there was no reason for it to address this issue, as the Bankruptcy Court order was unsound for the reasons articulated in the “heightened burden of proof” section of this article, and the Seventh Circuit, therefore, refrained from deciding, in this case, whether the critical vendor doctrine is a viable doctrine under the Bankruptcy Code.

Creditors objecting to critical vendor orders, or appealing the entry of such orders, will find the Seventh Circuit’s Kmart decision very encouraging precedent. If other courts are persuaded by the Seventh Circuit’s analysis that Section 363(b)(1) is the only possible justification for the entry of a critical vendor order, it is, in this author’s view, extremely likely that some of those courts will find that critical vendor orders are not permitted under the Bankruptcy Code under any circumstances. Section 363(b)(1) provides for use of property “other than in the ordinary course of business.” A very persuasive argument can be made, under the plain meaning doctrine, that payment of debts owed to so-called critical vendors is the classic example of a debtor’s use of property in the ordinary course of business, and that Congress would have used the words “in the ordinary course of administering an estate” if it had intended to do so.

Regardless of which side of the issue one is on, one thing is clear: The Kmart decision will not be the last word on the issue of critical vendor orders. The Seventh Circuit’s decision will undoubtedly lead to increased litigation over the use of critical vendor orders at both the bankruptcy court level, and at the appellate court level.

For more information, e-mail Stephen A. Bogorad at stephen.bogorad@hklaw.com or call toll free, 1-888-688-8500.

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1. In the Matter of Kmart Corporation, 2004 WL 343520 (7^th Cir. Feb. 24, 2004).

2. Under the distribution scheme contained in the Bankruptcy Code, prepetition general unsecured claims in a Chapter 11 case are to be paid pursuant to the terms of a confirmed plan after the payment of secured claims and priority claims, but prior to any return to equity holders.