Kmart Coporation v. Capital Factors Inc

Citation: Not availableDocket: 03-1956

Court: Court of Appeals for the Seventh Circuit; March 1, 2004; Federal Appellate Court

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Kmart Corporation, along with its affiliates, sought approval from the Bankruptcy Court to immediately pay all pre-petition claims of 2,330 "critical vendors" upon filing for bankruptcy. The rationale was that ensuring these vendors continued to supply goods was essential to Kmart's operations and would ultimately benefit its other creditors, even if they would not be fully paid. However, the Bankruptcy Judge granted this request without notifying the disfavored creditors or providing substantive evidence to support Kmart's claims about the necessity of these payments. The order allowed Kmart unilateral discretion to classify vendors as critical and pay off their debts, citing 11 U.S.C. § 105(a) but lacking legal analysis or rationale.

Kmart subsequently paid approximately $300 million to these vendors using $2 billion in debtor-in-possession financing, which prioritized the lenders over other post-petition assets. The remaining 2,000 vendors, classified as non-critical, received minimal compensation, around 10 cents on the dollar, primarily in Kmart stock. Capital Factors, Inc. appealed the critical-vendors order shortly after it was issued. Over a year later, as Kmart’s reorganization plan neared approval, District Judge Grady reversed the critical-vendors order, determining that neither § 105(a) nor the "doctrine of necessity" justified the relief originally granted.

Appellants argue that Judge Grady's intervention was too late to reverse payments made to critical vendors under bankruptcy proceedings, claiming that the funds cannot be refunded. However, the potential for reversing preferential transfers is a standard practice in bankruptcy, even post-confirmation of a reorganization plan, as established in Mellon Bank, N.A. v. Dick Corp. If the relevant orders are deemed invalid, Kmart can reclaim preferences granted to these vendors for the benefit of all creditors. Confirmation of a reorganization plan does not halt estate administration unless specified otherwise. While certain provisions of the Bankruptcy Code protect transactions completed under judicial orders, such protections do not extend to payments made to unsecured creditors labeled as "critical." 

Past cases suggest that courts can exercise equitable discretion when detrimental reliance, akin to new credit extensions, is present. However, in this instance, the appeals do not contest any asset distribution under Kmart’s confirmed plan, which explicitly allows for adversary proceedings to recover preferences granted to the critical vendors. Appellants' reliance interests, based on continued business with Kmart, do not constitute detrimental reliance since they were compensated fully for post-petition goods and services. If Kmart had faced administrative insolvency, a different scenario might justify the vendors retaining payments, but Kmart functioned as an operating business. 

Handleman Company, which received $49 million as a critical vendor, raised a procedural objection, asserting that it could not be bound by the district court's order since it was not named as an appellee in the notice of appeal. As Handleman was not a party in the district court, it argued that due process protects it from being affected by the ruling. The court allowed Handleman to intervene in the appeal process.

A party involved in a bankruptcy case must be named in notices of appeal according to Federal Rule of Bankruptcy Procedure 8001(a)(2). Handleman was not considered a party to the critical-vendors order as Kmart was the sole party at that time. Kmart's ex parte application did not specify any creditors, notifying only 65 out of 2,000 vendors affected by the order, which authorized Kmart to pay vendors deemed "critical" without designating any specific creditors. If Handleman was deprived of due process due to lack of notice, it would imply that Kmart’s actions deprived a larger group of unsecured creditors of due process, rendering the critical-vendors order void. However, bankruptcy law does not mandate personal notice to all creditors in contested matters, as a debtor represents multiple stakeholders' interests.

Handleman will receive necessary notice if Kmart pursues a preference-recovery action. As a party in this court, Handleman cannot contest resolved matters, and the decision will also apply to the 2,327 critical vendors not formally involved in this court. Individual notice is only required for those bound by a decision when practical, not for all potentially affected parties. The notice of appeal and the district judge's understanding that Kmart and Capital Factors were the only parties were deemed proper.

Section 105(a) empowers bankruptcy courts to issue orders necessary to enforce the Code but does not allow deviation from established rules on priority and distribution. Courts have consistently ruled that this section does not permit full payments of unsecured debts unless all creditors in that class are paid in full. The court emphasized that equitable proceedings do not grant judges discretion to redistribute rights based on personal notions of fairness, and a "doctrine of necessity" cannot be used to circumvent the Code.

Courts historically had the power to reorder creditor priorities in bankruptcy cases based on necessity, as illustrated in cases like Miltenberger v. Logansport Ry. and Fosdick v. Schall. However, the Bankruptcy Code of 1978 has supplanted these common-law doctrines, establishing that modern issues must be resolved within the framework of the Code. While older doctrines may provide context for ambiguous provisions, they cannot override the Code’s explicit text. 

Current bankruptcy law mandates equal treatment of creditors and outlines specific priorities, as indicated in sections such as 11 U.S.C. 507, 1122(a), and 1123(a)(4). Appellants have cited sections 363(b), 364(b), and 503 to justify unequal treatment of creditors, but §364(b) focuses on the authorization for a debtor to obtain credit without addressing creditor disbursement priorities. Similarly, §503 pertains to administrative expenses, which do not include pre-filing debts, emphasizing that these debts cannot be treated as administrative claims against a post-filing entity.

The concept of separating pre-filing debts from the post-filing entity's obligations is supported by case law, ensuring that old debts do not hinder a potentially viable business. Section 363(b)(1) allows a trustee to use estate property outside ordinary business operations, which could facilitate the payment of critical suppliers to maintain operations. However, there are concerns that interpreting this section too broadly may allow courts to improperly rearrange creditor priorities. While the Supreme Court has cautioned against such actions, if §363(b)(1) can be interpreted as a statutory basis for modifying priorities, it would not face insurmountable challenges. Nonetheless, it is advisable to apply this section in a manner that minimally disrupts established contractual priorities and other provisions of the Bankruptcy Code.

The court does not need to determine if §363(b)(1) could allow for the payment of pre-petition debts, as the order in question is flawed regardless of its interpretation. A critical-vendors order is based on the premise that vendors who have not been paid for prior deliveries will stop providing goods, potentially leading to the failure of a retailer like Kmart. If payments to critical vendors facilitate a successful reorganization and benefit even non-designated creditors, all creditors would support such payments. This rationale resembles that of a plan imposed on an impaired class of creditors, where objections are invalid if the impaired class fares as well as it would in a Chapter 7 liquidation.

For this premise to hold, it must be demonstrated that disfavored creditors would be as well off under reorganization as liquidation—a point not addressed in this case. Additionally, it must be shown that critical vendors would indeed cease deliveries if past debts remain unpaid during litigation. If vendors agree to continue deliveries in exchange for current payments, reorganization can proceed without favoring any unsecured creditor. Some vendors, such as Fleming Companies, which supplied significant goods to Kmart, would likely continue doing business due to long-term contracts and legal constraints preventing them from ceasing deliveries. Fleming had no legitimate reason to expect compensation for deliveries it was legally obligated to make and was unlikely to stop supplying Kmart given the profitability of new deliveries.

The text emphasizes that well-managed businesses do not forgo current profits due to prior losses, highlighting that Fleming's survival depended on Kmart's orders. When Kmart ceased its purchases, Fleming faced bankruptcy, indicating it would not voluntarily stop selling to Kmart. While suppliers may worry about past debts, reassurance regarding timely payment for new deliveries does not necessitate payment for pre-petition debts. Kmart could have utilized its $2 billion line of credit to assure vendors of payment for post-petition transactions instead of relying on pre-petition payments.

A standby letter of credit, backed by $2 billion, could have assured unpaid vendors of payment without altering business terms between Kmart and its vendors. If lenders were unwilling to issue such a letter, it would signal poor reorganization prospects and prompt liquidation. The bankruptcy court did not consider this option and found insufficient evidence that vendors would stop doing business with Kmart if pre-petition deliveries were unpaid. The court also did not conclude that discrimination among unsecured creditors was necessary for reorganization, nor did it determine that disfavored creditors were better off due to the critical-vendors order. The situation resembled the Chapter 13 case of In re Crawford, where unequal treatment of creditors is permissible only if it benefits the affected creditors. Since the record did not support the prospect of such benefits, the critical-vendors order was deemed improper and thus could not be upheld. The ruling was affirmed by the Seventh Circuit.