Often at the outset of business reorganization cases, the debtor-in-possession will request as one of its “first day” motions that the Bankruptcy Court allow it to pay “critical vendors.” Although these claims are unsecured claims that normally cannot be paid under bankruptcy law except pursuant to a chapter 11 reorganization plan, the theory behind allowing certain business debtors to pay “critical” vendors pre-petition claims is that the critical vendors would likely not do business with the debtor during the reorganization case unless their pre-petition claims are promptly paid. Stating the debtor’s position simply, unless such payments are made, the risk increases dramatically that the debtor’s reorganization would fail in its early stages.
At the outset of Kmart Corp‘s chapter 11 case, Kmart’s Bankruptcy Court approved an order that authorized Kmart to pay the pre-petition claims of 2,330 “critical” suppliers, which collectively received about $300 million. Another 2,000 or so vendors were not deemed ?critical? and were not paid. They and 43,000 additional unsecured creditors eventually received about 10¢ on the dollar under Kmart’s reorganization plan, mostly in stock of the reorganized Kmart. Fourteen months later, the District Court overruled the Bankruptcy Court’s critical vendor order, and Kmart appealed that decision to the 7th Circuit Court of Appeals.
Today, the 7th Circuit issued this decision that affirms the District Court’s order setting aside the Bankruptcy Court’s approval of Kmart’s payment of its critical vendor’s pre-petition claims. The decision is written a bit untidily — for example, the 7th Circuit describes the critical vendor payments as “preferential” (i.e, paid in preference to those of non-critical creditors). In reality, the critical vendor payments are post-petition payments and, by referring to them as preferential, the 7th Circuit risks confusion of those payments with voidable preferences, which can only be made prior to the commencement of a bankruptcy case. Nevertheless, the decision has a good overview on the law in this key area for business debtors, and is a good one for debtor’s counsel to review before making a record on the necessity for critical payments at the outset of a chapter 11 case.
Thanks to my old friend and former law partner, Joe Epstein of Winstead Sechrest & Minick P.C., for the pointer to this decision.