In re Kmart Corp.
359 F.3d 866, 2004 WL 343520 (2004)
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Rule of Law:
A bankruptcy court may not authorize payment of pre-petition claims to a select class of 'critical' unsecured creditors under the 'doctrine of necessity' or its general equitable powers in 11 U.S.C. § 105(a). While such payments may potentially be authorized under 11 U.S.C. § 363(b)(1), they require a specific evidentiary showing that the payments are necessary for a successful reorganization and will provide a tangible benefit to, or at least not harm, the disfavored unsecured creditors.
Facts:
- Kmart Corporation filed for Chapter 11 bankruptcy.
- On the first day of its case, Kmart sought to pay the full, pre-petition debts of 2,330 suppliers it unilaterally designated as 'critical vendors'.
- Kmart asserted that these payments were necessary because the vendors would otherwise refuse to provide goods, jeopardizing Kmart's ability to operate and reorganize.
- Approximately 45,000 other unsecured creditors, including Capital Factors, Inc., were not designated as 'critical' and were not slated for immediate payment of their pre-petition claims.
- Kmart offered no evidence that the designated vendors would actually cease doing business if not paid, nor that the proposed payments would benefit the disfavored creditors.
- Kmart ultimately paid about $300 million to the 2,330 'critical' vendors.
Procedural Posture:
- Kmart Corporation filed a motion in the U.S. Bankruptcy Court for permission to pay certain pre-petition vendor claims.
- The Bankruptcy Court entered a 'critical vendors' order granting the motion without notice to all creditors or an evidentiary hearing.
- Capital Factors, Inc., an unpaid unsecured creditor, appealed the Bankruptcy Court's order to the U.S. District Court.
- The District Court, with Judge Grady presiding, reversed the Bankruptcy Court's order.
- Kmart and Handleman Company (as an intervenor and recipient of a critical vendor payment) appealed the District Court's decision to the U.S. Court of Appeals for the Seventh Circuit.
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Issue:
Does the Bankruptcy Code, either through a 'doctrine of necessity,' the court's equitable powers under § 105(a), or its authority under § 363(b)(1), permit a debtor to pay the pre-petition, unsecured claims of certain vendors it deems 'critical' ahead of other similarly situated unsecured creditors?
Opinions:
Majority - Easterbrook, Circuit Judge.
No. The Bankruptcy Code does not permit a debtor to pay certain pre-petition unsecured creditors ahead of others without a rigorous factual showing that such preferential treatment is necessary and benefits all creditors. The court's authority under § 105(a) is to implement the Code's provisions, not override its fundamental priority scheme. The 'doctrine of necessity' is an outdated common-law concept from 19th-century railroad reorganizations that was superseded by the comprehensive Bankruptcy Code of 1978. While § 363(b)(1), authorizing use of estate property outside the ordinary course of business, is the most plausible source for such an order, its use here was improper. The bankruptcy court made no factual findings that the payments were essential to Kmart's survival or that the disfavored creditors would be better off. A debtor must prove, not just allege, that vendors would actually cease supplying goods and that the preferential payments are the only way to facilitate a reorganization that benefits the creditor body as a whole. Kmart failed to meet this burden, rendering the order invalid.
Analysis:
This decision severely restricts the common practice of granting 'critical vendor' motions on the first day of a large Chapter 11 case. It firmly rejects the judge-made 'doctrine of necessity' and insists that any departure from the Bankruptcy Code's priority scheme be grounded in a specific statutory provision and supported by a strong evidentiary record. By placing a high burden of proof on the debtor, the ruling reinforces the principle of equal treatment for similarly situated creditors and makes it significantly more difficult for debtors to favor key suppliers at the expense of others, thereby protecting the integrity of the Code's distribution rules.
