Protections For Vendors In A Customer's Bankruptcy May Not Be As Expected

Tuesday, June 1, 2004 - 01:00

Through favorable interpretations of the Bankruptcy Code (the "Code") and the equitable power of bankruptcy courts, vendors in certain cases have been able to avoid the potentially harsh consequences of a customer's bankruptcy. However, recent decisions in the Kmart bankruptcy case addressing the rights of both pre- and post-petition vendors underscore the risks to vendors in cases where the Code and the equitable discretion of bankruptcy courts are interpreted more narrowly than the vendor might hope. Vendors that understand these decisions and their potential influence on future cases will be less likely to rely solely on assurances by the debtor regarding the priority of their claims.

Pre-Petition Claims

One of the basic tenets of the Code is equality of treatment among pre-petition general unsecured creditors. However, bankruptcy courts have long recognized that the potential rehabilitation of the debtor may only be realized if certain "critical" vendors that are owed pre-petition debt (i.e., claims based on services provided to the debtor prior to the bankruptcy filing) are paid at the beginning of the bankruptcy proceeding, in advance of the debtor's plan of reorganization. The theory in support of critical vendor status is based on the "Doctrine of Necessity." The view is that vendors that are critical to the debtor's business will be more willing to continue to provide services and supplies to the debtor post-petition if they receive payment of some or all pre-petition debt. This, in turn, would allow the debtor to continue to provide its customers with the goods and services they expect and increase its chances of successfully reorganizing. Payment to critical vendors may also improve the ultimate position of other creditors who may receive a greater portion of their claim in reorganization than they would if the critical vendors cut off supplies and discontinued services and the debtor was forced to liquidate.

This "Doctrine of Necessity" is based in pre-Code nineteenth century railroad reorganizations where trustees acting under duress from creditors were permitted to pay pre-petition debt in order to obtain supplies and services necessary for the operation of the business. This doctrine has never been codified in the Code; however, numerous bankruptcy courts have deviated from the Code's established priorities and granted debtors' requests to pay pre-petition unsecured debt. These courts have found authority for such deviation in the equitable powers granted under Section 105 of the Code, which provides that "the court may issue any order, process or judgment that is necessary or appropriate to carry out the provisions of [the Code.]" 11 U.S.C. §105(a); see, e.g., Just for Feet, Inc., 242 B.R. 821 (D. Del. 1999); Michigan Bureau of Workers' Disability Comp. v. Chateaugay Corp., 80 B.R. 279 (S.D.N.Y. 1987).

However, in In re Kmart Corporation, 359 F.3d 866 (7th Cir. 2004), the Seventh Circuit made a forceful argument that critical vendor payments may, in fact, be inconsistent with the policies of the Code. In Kmart's Chapter 11 case, the bankruptcy court relied upon Section 105 of the Code to grant the debtor's request upon the commencement of the case to pay in full approximately $300 million in pre-petition debts that were owed to over 2,300 suppliers. Fourteen months later, on the eve of confirmation of Kmart's plan, the District Court reversed the order authorizing payment, concluding that neither Section 105 nor the "Doctrine of Necessity" supported the payments. Capital Factors, Inc. v. Kmart Corporation, 291 B.R. 818 (N.D. Ill. 2003).

On appeal, the Seventh Circuit upheld the District Court's decision and found that the filing of a bankruptcy petition essentially creates two separate entities, a pre-filing entity and a post-filing entity, and the treatment of the claims incurred by the pre-filing entity as claims against the post-filing entity impairs the Code's policy of preventing old debts from sinking a viable reorganized enterprise. The Seventh Circuit found that the use of Section 105 to support critical vendor payments was inconsistent with the furtherance of Code principles.

Despite these conclusions, the Seventh Circuit left open the possibility that post-petition payments to critical vendors for pre-petition debts may be permissible under Section 363(b)(1) of the Code, which permits a debtor after notice and a hearing to use estate property outside of the ordinary course of business. However, the Seventh Circuit suggested that the debtor must show not only that other creditors would be at least as well off in a reorganization as they would in a liquidation, but also that the purportedly critical vendors would have ceased doing business with the debtor if pre-petition debts were left unpaid. If, in fact, such vendors would continue to conduct business with the debtor despite not receiving such payments or simply must continue to do business with the debtor for the sake of their own viability, then judicial alteration of priorities established by the Code is not appropriate according to the Seventh Circuit.

There are several practical impediments to showing that a vendor is "critical" under the Seventh Circuit's test. For example, although a court must find that the vendor will not do business with the debtor absent payment, actions and statements by a vendor suggesting that such vendor will not do business with the debtor but for payment (such as walking away from a contract) may be viewed as violations of the automatic stay that protects the debtor from any actions to collect, assess or recover a pre-petition claim. See, 11 U.S.C. §362(a)(6). In addition, even if the vendor has a legal right to walk away from a contract, it may be difficult for a vendor to make a persuasive argument that it is willing to forego providing the debtor with products and services because of old debts if post-petition the debtor will be able to pay for such new products and services. The influence of the Seventh Circuit's decision remains to be seen, but it appears that courts applying the Seventh Circuit's reasoning would only grant critical vendor status in very extraordinary cases.

Post-Petition Claims

Another issue arising out of Kmart's bankruptcy is the ability of vendors that have provided post-petition services to obtain priority status over pre-petition general unsecured creditors. Claims entitled to such priority, known as "administrative expenses" include "the actual, necessary costs and expenses of preserving the estate, including wages, salaries, or commissions for services rendered after the commencement of the case." 11 U.S.C. §503(b)(1). In a Chapter 11 case, the debtor will not be permitted to confirm a plan of reorganization unless it provides for payment in full in cash of all administrative expenses, unless the holders of such claims that have not yet been paid agree to different treatment. 11 U.S.C. §1129(a)(9)(A).

Other than "wages, salaries and commissions," the Code does not specifically identify categories of expenses that may presumptively qualify as administrative expenses. However, in general, expenses incurred by the debtor after the filing of a petition may be deemed to be administrative expenses if such expenses benefit the estate. Reading Co. v. Brown, 391 U.S. 471, 88 S. Ct. 1759, 20 L. Ed. 2d 751 (1968). In addition, expenses that do not necessarily provide a benefit to creditors but nonetheless are necessary have been afforded administrative status. See, e.g., In re Klein Sleep Products, Inc., 78 F.3d 18 (2d Cir. 1996) ("benefit" is one factor in determining administrative expense status).

However, as demonstrated by the bankruptcy court's decision in In re Kmart Corporation, 293 B.R. 905 (Bankr. N.D. Ill 2003) ("Kmart/JDA"), a narrow interpretation of Section 503(b)(1) of the Code could yield surprising results for a creditor who performs services at the request of a debtor-in-possession. In the Kmart case, a software company, JDA Software, Inc. ("JDA"), entered into several agreements with Kmart prior to the bankruptcy filing to develop, deliver, install and support software that would integrate new Kmart stores in the Caribbean into Kmart's existing systems. Prior to the bankruptcy filing, JDA installed the software. After the bankruptcy filing, Kmart informed JDA that the project was "still a go" and requested that JDA continue to perform services under the contracts. Further, Kmart expressly promised JDA that it would be afforded administrative expense status. However, shortly after the bankruptcy filing Kmart advised JDA that the opening of the Caribbean stores would be delayed and that JDA's services were no longer needed. Kmart deleted the software from its computer systems and rejected the contracts with JDA.

Despite JDA's performance pursuant to its pre-petition contract with Kmart and Kmart's specific request that JDA continue to perform post-petition services, the court found that because Kmart did not ultimately use the software that JDA provided, JDA had not provided an actual, concrete benefit to the operation of the debtor's business. Therefore, JDA was not entitled to an administrative claim. Although JDA argued that Kmart acknowledged the benefit of the services provided by virtue of Kmart's request that they be performed post-petition, the Court held that post-petition performance alone does not automatically translate into a benefit to the estate, even if there was inducement on the part of the debtor. In drawing its conclusion, the court relied on the decision in In re Enron Corp., 279 B.R. 695 (Bankr. S.D.N.Y. 2002), where it was held that the potential benefit to the estate of available, but unused, pipeline capacity did not support an administrative claim by the provider of such additional capacity. Similarly, JDA's performance was held to be too speculative to be allowed as an "actual, necessary cost and expense of preserving the estate." As a result of the rejection of its pre-petition contracts by Kmart, JDA was left with a pre-petition unsecured damage claim.

The recent cases involving the Kmart bankruptcy demonstrate the difficulties faced by vendors when seeking to obtain priority of payment over other general unsecured creditors. The Kmart/JDA case in particular underscores the importance to vendors of taking affirmative steps to protect their interests when transacting business with debtors-in-possession. With respect to an unperformed pre-petition contract, the vendor could seek to compel the debtor to assume the contract. Depending on the circumstances, a cautious vendor might want to proceed on the assumption that administrative claim status will not be available and request a payment method such as payment in advance or payment upon delivery or seek to secure the debtor's payment obligations through a letter of credit. However, when structuring such post-petition transactions, one must be mindful as to whether the transaction will be viewed as being outside of the ordinary course of business and thus an unauthorized transfer of the debtor's property that is subject to avoidance by the trustee. See, 11 U.S.C. §549. A cautious vendor might guard against this risk by seeking bankruptcy court approval for the transaction to ensure that the trustee does not seek the return of amounts paid.

In the end, an independent understanding of the risks, rather than mere reliance on assurances by the debtor, is critical to reducing the vendor's exposure in the bankruptcy of its customer.

Joseph Cioffi is a partner in the Corporate Department of New York based Davis & Gilbert LLP.

Please email the author at jcioffi@dglaw.com with questions about this article.