Carney, Ryan K.

English

Southern Methodist University

SMU Law ReviewVolume 57 | Issue 2 Article 52004Bankruptcy - Pre-Plan Authorizations - NorthernDistrict of Illinois Prohibits First Day Orders andPreplan Authorizations for Prepetition DebtRyan K. CarneyFollow this and additional works at: https://scholar.smu.edu/smulrThis Case Note is brought to you for free and open access by the Law Journals at SMU Scholar. It has been accepted for inclusion in SMU Law Reviewby an authorized administrator of SMU Scholar. For more information, please visit http://digitalrepository.smu.edu.Recommended CitationRyan K. Carney, Bankruptcy - Pre-Plan Authorizations - Northern District of Illinois Prohibits First Day Orders and Preplan Authorizationsfor Prepetition Debt, 57 SMU L. Rev. 473 (2004)https://scholar.smu.edu/smulr/vol57/iss2/5BANKRUPTCY-PRE-PLANAUTHORIZATIONS-NORTHERNDISTRICT OF ILLINOIS PROHIBITSFIRST DAY ORDERS AND PRE-PLAN AUTHORIZATIONS FOR PRE-PETITION DEBTRyan K. CarneyANKRUPTCIES today are growing more complex, but are alsoincreasingly more accepted as an option for business survival andcompetition. As bankruptcy judges have attempted to deal withthe realistic problems presented by complex debtors having dozens, if nothundreds, of creditors while attempting to reorganize under Chapter 11and emerge as healthier business entities, the use of "first day orders" or"pre-plan payments" have allowed them to make practical decisions andkeep companies functional.1 However, in Capital Factors, Inc. v. KmartCorp.,2 Judge Grady for the Northern District of Illinois calls this practiceinto question by ruling that pre-plan payments are prohibited by theBankruptcy Code.3 Unfortunately for companies faced with reorganiza-tion, if higher courts agree with Judge Grady, this highly practical solu-tion may soon see the end of its day in court.4 This note will show,however, that Judge Grady's conclusion is fatally flawed because his anal-ysis does not adequately analyze the Supreme Court's "doctrine of neces-sity ' 5 and its effect in conjunction with the Chapter 11 Bankruptcy Code.Kmart Corp. ("Kmart"), a nationwide supermarket chain, "filed a vol-untary petition for reorganization pursuant to Chapter 11 of the . . .Bankruptcy Code" on January 22, 2002.6 As is common practice, theyimmediately filed a motion to authorize payment of "prepetition obliga-1. See generally Capital Factors, Inc. v. Kmart Corp., 291 B.R. 818, 820-21 (N.D. Ill.2003) (acknowledging the utility of pre-plan authorizations).2. Id.3. Id. at 822-23.4. See id. at 823 (Judge Grady found that pre-plan authorizations were not authorizedin the code and that they were therefore beyond the equitable powers of bankruptcyjudges).5. See Miltenberger v. Logansport C. & S.W.R. Co., 106 U.S. 286 (1882) (approvingof certain payments of pre-petition debt to secure critical supplies or services).6. Kmart Corp., 291 B.R. at 820.SMU LAW REVIEWtions to certain 'critical vendors." 7 These vendors were deemed criticalfor a variety of reasons and included foreign vendors and alcohol suppli-ers.8 It is not entirely clear from the facts that all the so-called "criticalvendors" were actually "critical." 9 Capital Factors, Inc. ("Capital"), anunsecured creditor of Kmart, objected to such payments because they be-lieved that payment of the "critical vendors" would reduce the likelihoodthat they would recover the more than twenty million dollars they wereowed by Kmart.10 However, "Kmart contended that these paymentswere necessary to maintain relationships essential to its continued opera-tion and reorganization.""After hearing evidence on the motions filed regarding the pre-planpayments, the bankruptcy judge ordered the payments over Capital's ob-jections.' 2 The bankruptcy judge decided that payment of "critical ven-dors" was in the best interest of all creditors if it facilitated the process ofChapter 11, but he admitted that bankruptcy judges are "seeing more andmore [first day orders for pre-plan authorizations] and ... have to stretchto find some authority to do them."1' 3 Capital appealed that ruling to theNorthern District of Illinois claiming, inter alia, that pre-plan authoriza-tions are not permissible and that if they are, they were not proper in thiscase.14Although the precedential value of Kmart Corp., is limited,' 5 it repre-sents a crucial decision being made in bankruptcy courts today.1 6 Thecourt was faced with a run-of-the-mill bankruptcy in which the debtor inpossession filed a routine request to pay pre-petition debts to "criticalvendors" in order to maintain a functional relationship and pursue thegoals of Chapter 11.17 The court then had to decide, as will future courts,whether the highly practical use of pre-plan authorizations under the"doctrine of necessity" is admissible under the Bankruptcy Code as itstands. 18The Northern District of Illinois United States District Court holds thatpre-plan authorizations, "however useful and practical [they] may appearto bankruptcy courts, they simply are not authorized by the BankruptcyCode" and are therefore not admissible. 19 Many courts have used 11U.S.C. § 105(a), which states that "[t]he court may issue any order, pro-cess, or judgment that is necessary or appropriate to carry out the provi-7. Id.8. Id.9. Id.10. Id.11. Id.12. Id.13. Id. (quoting App. to Appellee's Brief Ex. 4A, at 162).14. See id. at 821 (discussing issues raised on appeal).15. The only courts required to follow the Northern District of Illinois District Courtholdings are the bankruptcy courts in the Northern District of Illinois.16. Kmart Corp., 291 B.R. at 820.17. Id. at 820-21.18. See generally id. at 822.19. Id. at 823.[Vol. 57Casenotesions of this title,"'20 as a basis for their equitable powers to grant pre-plannlthorizations.21 Judee Gradv, however, holds that based on the SeventhCircuit's interpretation that 11 U.S.C. § 105(a) "allows [bankruptcy]courts to use their equitable powers only as necessary to enforce the pro-visions of the Code," the power to grant pre-plan authorizations does notexist where there is no authorization found in the Bankruptcy Code.22Judge Grady does admit, however, that "[t]here is a split in the courtsregarding whether § 105 authorizes bankruptcy courts to permit pre-planpayment of pre-petition unsecured claims."'23Both Kmart and Capital are able to cite several courts that would sup-port their arguments, but Judge Grady points out that Capital cites higherauthority relative to those cases cited by Kmart. 24 Capital is able to claimthat three courts of appeals have ruled on similar issues to constrain theequitable powers granted by § 105.25 However, Kmart can rely on a longhistory of bankruptcy courts using the equitable powers under § 105 inconjunction with the common law "doctrine of necessity" as recognizedby the Supreme Court to help entities under Chapter 11 successfullymaintain business relationships that are crucial to their futureprofitability. 26Although Judge Grady bases his opinion on authority that limits theequitable powers granted in 11 U.S.C. § 105 to bankruptcy judges inother related matters, 27 his use of that persuasive authority28 is not con-vincing for several reasons. First, he summarily includes the common law"doctrine of necessity" in with § 105, subjecting it to the restrictions setforth against § 105's equitable powers that were not related to the "doc-trine of necessity" and "critical vendors. '29 Second, the cases he cites inorder to support his conclusion are generally not on point. 30 Last andmost importantly, when he determines that the Bankruptcy Code doesnot authorize pre-plan payments, he does not explore the fact that theoverriding purpose of Chapter 11 may implicitly justify the equitable so-20. 11 U.S.C. § 105(a) (2003).21. See Kmart Corp., 291 B.R. at 822; In re Just For Feet, Inc., 292 B.R. 821, 824 (D.Del. 1999).22. Kmart Corp., 291 B.R. at 822 (quoting In re Fresco Plastics Corp., 996 F.2d 152,156 (7th Cir. 1993)).23. Id.24. Id.25. See id. (citing Official Comm. of Equity Sec. Holders v. Mabey, 832 F.2d 299 (4thCir. 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 & Assoc. (In re Oxford Mgmt., Inc.), 4 F.3d1329 (5th Cir. 1993); In re FCX, Inc., 60 B.R. 405 (E.D.N.C. 1986); In re Timberhouse Post& Bean, Ltd., 196 B.R. 547 (Bankr. D. Mont. 1996)).26. Id. at 822.27. Id. at 822 (listing cases for discussion of authority).28. See id. at 822 (see cases cited supra note 25).29. Id. at 823.30. See id. See infra text accompanying notes 37-48.2004]SMU LAW REVIEWlution when considered in conjunction with § 105. 3 1The "doctrine of necessity" was acknowledged by the U.S. SupremeCourt in the restructuring of railroads32 "as justification for the paymentof pre-petition debts paid under duress to secure continued supplies orservices essential to the continued operation of the railroad. '33 The doc-trine was based on the premise that the public was well-served by contin-ued service of the railroads.34 This doctrine has since been applied tobusinesses in other industries after Judge Learned Hand "held that acourt was not 'helpless' to apply the rule to non-railroad debtors. ' 35 It iscommon sense that if a business is worth more as a going entity thanselling its assets, then the public good is better served by allowing theorganization to make the necessary payments to secure the needed sup-plies and credit for future operations and profitability. Judge Grady here,however, has determined that because this "doctrine is not codified...the only way to apply it is through § 105."36 Combining the "doctrine ofnecessity" in as part of § 105, allows him to minimize it as a factor whenhe applies cases that restrict equitable powers under § 105.Although Judge Grady comments that the case law seems stronger infavor of prohibiting pre-plan payments,37 the cases that he has referencedin support of Capital are not controlling authority and for the most partare not on point.38 For example, the court in Official Committee of Eq-uity Security Holders v. Mabey,39 does restrict a judge's range of equitableactions, but does not refer to the "doctrine of necessity," nor does it everaddress pre-plan authorizations for "critical vendors. '40 In Mabey, for-mer users of the Dalkon Shield, a medical device used for birth control,were suing the manufacturer for infertility caused by its use.41 The equi-table action prevented by the court was the creation of an emergencytreatment fund authorizing the debtor to pay for many of the plaintiffs'surgical procedures before the bankruptcy plan was finished.42 This ac-tion, however generous to the victims, did not affect the debtor's abilityto reorganize and continue business operations; therefore, the "doctrineof necessity" was not applicable nor was it discussed. 43 The same criti-31. See NLRB v. Bildisco & Bildisco, 465 U.S. 513, 528 (1984) (stating "[tjhe funda-mental purpose of reorganization is to prevent a debtor from going into liquidation, withan attendant loss of jobs and possible misuse of economic resources.").32. See Miltenberger v. Logansport C. & S.W.R. Co., 106 U.S. 286 (1882).33. Kmart Corp., 291 B.R. at 822 (citing B&W Enters., Inc v. Goodman Oil Co. (In reB&W Enters., Inc.), 713 F.2d 534, 537 (9th Cir. 1983)).34. See generally Miltenberger, 106 U.S. at 286.35. In re Ionosphere Clubs, Inc., 98 B.R. 174, 176 (Bankr. S.D.N.Y. 1989) (citing JudgeLearned Hand from Dudley v. Mealey, 147 F.2d 268 (2d Cir. 1945), cert. denied, 325 U.S.873 (1945)).36. Kmart Corp., 291 B.R. at 822.37. Id.38. See id.; see cases cited supra note 25.39. 832 F.2d 299, 301 (4th Cir. 1987).40. See id.41. Id.42. Id.43. Id.[Vol. 57Casenotecism applies to In re Oxford Management. Inc.44 This case restricted acourt's ability to order a debtor to pay a broker's commission based on atangential legal issue, but the broker was not a "critical vendor" becausethe services were not ongoing, and again the court did not apply or dis-cuss the "doctrine of necessity" or "critical vendors. '45 Judge Grady'suse of these cases depends upon analogizing one restriction on a bank-ruptcy judge's power to another, but the analogy is not valid because inKmart Corp., the equitable power used is supported with the "doctrine ofnecessity" and the overriding purpose of Chapter 11. The only higherauthority relied upon by Judge Grady that even mentions "critical ven-dors" is B&W Enterprises v. Goodman Oil Co. (In re B&W Enterprises,Inc.),46 and the analysis in that case fails to adequately consider the pur-pose of Chapter 11 and the Supreme Court's "doctrine of necessity."47Thus, the court's analysis in B&W Enterprises, as merely persuasive au-thority, is subject to the same criticism as Judge Grady's analysis in KmartCorp. The case law that Judge Grady finds strong48 appears weak whenscrutinized in comparison to the actual issues presented in Kmart Corp.Perhaps Judge Grady's most incomplete conclusion is that § 105 pro-hibits pre-plan payments for "critical vendors" because they are not au-thorized in the Bankruptcy Code. 49 This conclusion is based on Capital'sargument that the pre-plan payments re-prioritize creditors in a way thatis not codified in the Bankruptcy Code because "[t]he Code does notcarve out priority.., for prepetition general unsecured claims based onthe 'critical' or 'integral' status of a creditor. '50 Although pre-plan pay-ment of "critical vendors" may not be explicitly authorized, the entireconcept of Chapter 11 implicitly authorizes such payments because "pay-ing certain pre-petition claims may be necessary to realize the goal ofchapter 11-a successful reorganization." 51 Chapter 11 exists for the pur-pose of restructuring entities that are worth more as ongoing concernsthan they are if their assets are sold off; a major part of such a determina-tion is based on the assumption that the firm will still be able to conductbusiness.52 The question of the priority of creditors must be second tothe survival and reorganization of the entity because the U.S. SupremeCourt has held that "the paramount policy and goal of Chapter 11, towhich all other bankruptcy policies are subordinated, is the rehabilitationof the debtor. '53 As such, the issue is not the priority of debtors repaid,44. 4 F.3d 1329 (5th Cir. 1993).45. Id. at 1333-3446. 713 F.2d 534, 537 (9th Cir. 1983).47. Id.48. Kmart Corp., 291 B.R. at 822-23; see cases cited supra note 25.49. Id. at 823.50. Id. at 822.51. In re Just For Feet, Inc., 242 B.R. 821, 825-26 (D. Del. 1999).52. Id.53. In re Ionosphere Clubs, Inc., 98 B.R. 174 (Bankr. S.D.N.Y. 1989) (quoting NLRBv. Bildisco & Bildisco, 465 U.S. 513, 528 (1984) which stated "[t]he fundamental purpose ofreorganization is to prevent a debtor from going into liquidation, with an attendant loss ofjobs and possible misuse of economic resources.").2004]SMU LAW REVIEWbut the survival and profitability of the reorganized entity enabling allcreditors to be repaid.Clearly there are many situations where a debtor entity will not be ableto survive without certain "critical vendors." Historically speaking, oneof the most common "critical vendors" would be the debtor's employees,because if the employees were not compensated for past work, theywould not continue to work, nor could the debtor hire willing labor insuch a situation. "Critical vendor" status could also be met by a vendorthat could not survive to supply the debtor if not repaid during the reor-ganization process. Admittedly, in Kmart Corp. there may have beenvendors included in the Critical Vendors Motion which were not actually"critical" because the case does not provide facts that prove they were;however, that is not reason to eliminate pre-plan payments for those ven-dors who are actually "critical."' 54 For instance, in In re Just For Feet,55the survival of their chain of shoe superstores required a profitable holi-day shopping season, which in turn would require mass shipments of newshoes for inventory from all of the major shoemakers.56 These vendorswould clearly qualify as "critical vendors," and due to the outstandingdebt owed to these vendors, they were not willing to ship additional in-ventory without payment on outstanding accounts.57 Clearly under thepremise of Chapter 11, such payments would be implicitly authorized be-cause all creditors, secured and unsecured, would be better served by aprofitable holiday shopping season. Fortunately, the Delaware courtagreed and found that where the "[tihe Supreme Court, the Third Circuitand the District of Delaware all recognize the court's power to authorizepayment of pre-petition claims when such payment is necessary for thedebtor's survival during chapter 11," the cases to the contrary represent aminority and misguided opinions.58Being unable to pay "critical vendors"' pre-petition debts when neces-sary to continue business may spell disaster for future debtors in theNorthern District of Illinois due to Judge Grady's unfortunate holding.Although there is valid criticism for judges who refuse to enforce the lawsas written, here the purpose of Chapter 11 in conjunction with 11 U.S.C.§ 105(a) and the Supreme Court's "doctrine of necessity" clearly supportthe continued use of pre-plan authorizations for "critical vendors." Fur-thermore, before prohibiting pre-plan payments, Judge Grady even ad-mits that the "doctrine of necessity" "is well-intended and may even havesome beneficial results... minimiz[ing] disruptions in doing business andthus may further reorganization. ' 59 Hopefully, the Seventh Circuit willreverse Judge Grady on appeal and will articulate carefully for futurecourts who must consider the viability of this highly practical solution that54. Kmart Corp., 291 B.R. at 820-21.55. 242 B.R. 821 (D. Del. 1999).56. Id. at 823-24.57. Id.58. Id. at 825.59. Kmart Corp., 291 B.R. at 823.[Vol. 572004] Casenote 479the Supreme Court's "doctrine of necessity" is alive and well, protectingdebtors from being forced into liquidation because of the gridlock im-posed on them under the Bankruptcy Code.480 SMU LAW REVIEW [Vol. 57

Bankruptcy - Pre-Plan Authorizations - Northern District of Illinois Prohibits First Day Orders and Preplan Authorizations for Prepetition Debt

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Bankruptcy - Pre-Plan Authorizations - Northern District of Illinois Prohibits First Day Orders and Preplan Authorizations for Prepetition Debt

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