In re Jeans.com, Inc.

Citations: 502 B.R. 250; 70 Collier Bankr. Cas. 2d 1439; 2013 Bankr. LEXIS 4985; 58 Bankr. Ct. Dec. (CRR) 212; 2013 WL 6133527Docket: No. 13-07491 (ESL)

Court: United States Bankruptcy Court, D. Puerto Rico; November 20, 2013; Us Bankruptcy; United States Bankruptcy Court

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The court granted the Debtor's Motion to Denominate Critical Vendors, allowing for payment to certain essential suppliers deemed critical for the Debtor's operations and reorganization. The Debtor filed for Chapter 11 bankruptcy on September 11, 2013, and on September 20, requested authorization to pay pre-petition amounts to these vendors, claiming their services were vital for business continuity. Creditors DDR Norte LLC and related entities opposed the motion, arguing that the Debtor did not provide sufficient evidence and that the request effectively sought post-petition financing without meeting the necessary legal requirements under the Bankruptcy Code and corresponding rules. In a reply, the Debtor maintained that these payments were essential for ongoing operations and potential profitability. During the hearing on October 18, 2013, the court acknowledged some legal disagreements but ultimately found sufficient evidence to support the designation of critical vendors and the proposed payment amounts, capped at $5,000 per month. The court asserted jurisdiction over the case as a core proceeding under relevant statutes. The opinion outlines the rationale for granting such orders, emphasizing their role in encouraging creditors to maintain business relationships during the Chapter 11 process to preserve the Debtor's enterprise value.

Orders permitting the payment of pre-petition debts in Chapter 11 bankruptcy cases have faced significant criticism for potentially violating the Bankruptcy Code’s principle of equal distribution among creditors, as established in Begier v. IRS. Currently, the Bankruptcy Code lacks explicit provisions allowing such payments before a reorganization plan is confirmed, and there is no statutory definition for “critical vendors.” Despite this, critical vendor orders have become common practice, justified under the “doctrine of necessity,” which allows debtors to pay certain unsecured claims to essential creditors prior to plan confirmation. This doctrine, rooted in historical railroad receivership cases, aims to facilitate the debtor's survival and successful reorganization, benefiting all stakeholders including employees, vendors, equity holders, and unsecured creditors. It operates under the bankruptcy court's equitable powers granted by 11 U.S.C. § 105, which allows courts to issue necessary orders to implement the Bankruptcy Code’s provisions. The doctrine of necessity, alongside the "six-month rule," emerged from 19th-century legal precedents that recognized an equitable priority for creditors vital to ongoing business operations.

To qualify for payment under the critical vendor doctrine, a creditor must prove that the obligation was incurred within six months before the receivership began, granting them equitable priority over other creditors. This principle, rooted in the necessity of payment doctrine established in *Miltenberger v. Logansport Railway Co.*, allows courts to prioritize payments to certain unsecured creditors to ensure continued delivery of essential services and goods, thereby facilitating the debtor's operational viability. This doctrine has evolved from its initial application in railroad reorganizations, where public interest necessitated continued operations, to broader applications in bankruptcy cases, enabling courts to enhance reorganization efforts and protect creditor interests. The six-month rule, embedded in Section 77(b) of the Bankruptcy Act of 1898 and carried through the Bankruptcy Reform Act of 1978, explicitly allows ordinary course claims incurred within that timeframe to be prioritized over secured claims. Courts, however, have limited this doctrine's application to circumstances where the payment is essential to maintain the supply of critical goods and services post-bankruptcy filing.

The "doctrine of necessity" is not codified in the Bankruptcy Reform Act of 1978, unlike the six-month rule. Courts have typically invoked this doctrine, especially beyond railroad reorganizations, by utilizing the equitable powers granted in Section 105(a) of the Bankruptcy Code. For instance, in *In re Just for Feet, Inc.*, the court acknowledged that it can authorize pre-petition claims when necessary for a debtor's survival. Prior to the *Kmart* case, bankruptcy courts commonly granted critical vendor motions under this doctrine, as seen in cases like *In re Ionosphere* where courts provided broad discretion to pay pre-petition claims if justified by business needs. In *Just for Feet, Inc.*, the debtor sought to pay trade creditors to secure inventory vital for the holiday season, despite objections based on the authority of Section 105(a). The court ultimately ruled that such payments were necessary for the debtor's survival, citing the CEO's testimony on the importance of the claims for business continuity. However, the *Kmart* case established a two-prong test that increased the burden on debtors seeking similar motions, generating concerns about the viability of critical vendor payments moving forward.

In Kmart, the debtors, including a retailer and thirty-eight affiliates, sought to pay approximately $300 million to 2,330 vendors for pre-petition claims on the first day of their bankruptcy case, arguing that failure to do so would disrupt their ability to reorganize and harm all creditors. The Bankruptcy Court for the Northern District of Illinois initially granted this motion, but the ruling was appealed by disfavored vendors. The District Court reversed the decision, a ruling later affirmed by the Seventh Circuit. The Seventh Circuit criticized the bankruptcy court for approving the motion without evidence that it would not harm disfavored creditors, stating that the doctrine of necessity could not justify departing from the Bankruptcy Code. It clarified that while 11 U.S.C. § 368(b)(1) allows preferential payments under specific conditions, the debtor must prove that vendors would cease business if debts were unpaid and that disfavored creditors would not be adversely affected by such payments.

In the First Circuit, the Supreme Court in Norwest Bank Worthington v. Ahlers established that bankruptcy courts' equitable powers under Section 105 must align with the Bankruptcy Code, and cannot create rights or expand obligations that are not defined in the Code. The First Circuit has cautioned against the overuse of Section 105(a), emphasizing that its equitable remedies must be necessary to preserve specific rights conferred by the Code. The only notable case addressing critical vendor orders in the First Circuit is In re Zenus Is Jewelry, Inc., where a jewelry retailer sought to pay prepetition claims of five vendors in exchange for credit extensions.

The court denied the requested payments, clarifying that the case did not involve a critical vendor issue since vendors would supply inventory on a cash-on-delivery basis. Additionally, alternative sources for the same product were available to the debtor. The court emphasized that the "necessity of payment" doctrine should be reserved for "extraordinary circumstances" and "rare cases," referencing prior cases such as Kmart and In re CoServ. The Bankruptcy Court for the District of Puerto Rico applied the "doctrine of necessity" using a three-prong test from In re CoServ: 1) Assessing if dealing with the vendor is critical; 2) Determining if the debtor faces disproportionate harm without the vendor; and 3) Evaluating if there are no practical or legal alternatives to payment. The District Court upheld the Bankruptcy Court’s findings, affirming the appropriateness of using the In re CoServ analysis under Section 105(a) of the Bankruptcy Code. It further supported the use of Section 105 to affirm Section 1107(a), which empowers the debtor-in-possession to operate for the benefit of creditors. The District Court highlighted that a Chapter 11 trustee or debtor-in-possession has a fiduciary duty to protect the estate, including the going concern value of the business. The court also adopted reasoning from In re Tropical Sportswear Int’l Corp., stating that while Section 105 alone is insufficient for critical vendor payments, it can be used alongside Section 363 under suitable conditions.

The Bankruptcy Code is designed to address the economic challenges faced by debtors during reorganization, as outlined in Section 363(b), which allows trustees or debtors-in-possession to use, sell, or lease estate property outside the ordinary course of business after notice and hearing. The court highlights the importance of paying critical vendors to ensure the continuity of essential supplies, which is crucial for the debtor’s survival. Payments to these vendors may be justified if: (i) they are necessary for the reorganization; (ii) the vendors would refuse to supply unless designated as critical; and (iii) disfavored creditors would not be worse off than without these payments. The court emphasizes that such equitable powers should be exercised only when the critical vendors are genuinely essential and the payments are negotiated at arm's length, improving the bankruptcy estate for the benefit of all creditors. The court also cites additional authority from Section 1107(a), reinforcing the debtor-in-possession's duty to protect the estate's value. The factors established in *Tropical Sportswear Int’l Corp.* will guide the court’s determination on critical vendor payments.

The court, following a hearing on October 18, 2013, determined that the Debtor met all three necessary requirements for the designation of critical vendors. The identified critical vendors include Islandwide Express, Inc.; Five Stars Accessories; Dali Overseas Corp.; Magic Transport, Inc.; Riflessi; NEU Enterprises, Inc.; H. H Distribution, LLC; Triple Gear, Inc.; and Safire Lounge. The Debtor provided Unsworn Declarations under penalty of perjury explaining the role of these vendors in supporting the Debtor's operations, although these declarations were not formally entered into evidence during the hearing. Mr. Michael Silva, the Debtor’s president, presented credible testimony detailing the necessity of payments to these vendors for successful reorganization, citing factors such as reliable merchandise availability, suitability for the Puerto Rican market, credit terms, quality, and willingness to offer special pricing.

The letters from the critical vendors indicated that they would cease supply if not granted critical vendor status, which constituted a valid business justification for the request. The court found that disfavored creditors would not be worse off under the critical vendor order, as payments to these vendors would facilitate a successful reorganization. This reasoning is supported by precedent from Tropical Sportswear Int’l Corp., which states that if an impaired class of creditors is at least as well off as in a Chapter 7 liquidation, it cannot object to the reorganization. The court also found no evidence to suggest that the Debtor’s proposed budget for pre-petition payments to the critical vendors was not conducted at arm's length. Consequently, the Debtor’s Motion to Denominate Critical Vendors was granted, allowing payments as proposed.