Kmart Coporation v. Capital Factors Inc ( 2004 )

In
 the
United
 States
 Court
 of
 Appeals
For
 the
 Seventh
 Circuit
____________________
Nos. 03-1956, 03-1999, 03-2000, 03-2001, 03-2035, 03-2262, 03-2346,
03-2347 ﹠ 03-2348
In the matter of:
Kmaʀt Coʀpoʀatɪoɴ,
Debtor-Appellant
Additional intervening appellants:
Kɴɪɢʜt-Rɪddeʀ, Iɴc.; Haɴdʟemaɴ Compaɴʏ; Iʀvɪɴɢ Puʟp
﹠ Papeʀ, Lɪmɪted
____________________
Appeals from the United States District Court for the
Northern District of Illinois, Eastern Division.
No. 02 C 1264 et al. — John F. Grady, Judge.
____________________
Aʀɢued Jaɴuaʀʏ 22, 2004 — Decɪded Feʙʀuaʀʏ 24, 2004*
____________________
Before Easteʀʙʀook, Maɴɪoɴ, and Rovɴeʀ, Circuit Judges.
Easteʀʙʀook, Circuit Judge. On the first day of its bankruptcy,
Kmart sought permission to pay immediately, and in full, the pre-
petition claims of all “critical vendors.” (Technically there are 38
debtors: Kmart Corporation plus 37 of its affiliates and subsidiaries.
We call them all Kmart.) The theory behind the request is that
some suppliers may be unwilling to do business with a customer
that is behind in payment, and, if it cannot obtain the merchandise
that its own customers have come to expect, a firm such as Kmart
may be unable to carry on, injuring all of its creditors. Full pay-
* This opinion is being released in typescript. A printed copy will follow.
Nos. 03-1956 et al. Page 2
ment to critical vendors thus could in principle make even the dis-
favored creditors better off: they may not be paid in full, but they
will receive a greater portion of their claims than they would if the
critical vendors cut off supplies and the business shut down. Put-
ting the proposition in this way implies, however, that the debtor
must prove, and not just allege, two things: that, but for immediate
full payment, vendors would cease dealing; and that the business
will gain enough from continued transactions with the favored
vendors to provide some residual benefit to the remaining, disfa-
vored creditors, or at least leave them no worse off.
Bankruptcy Judge Sonderby entered a critical-vendors order
just as Kmart proposed it, without notifying any disfavored credi-
tors, without receiving any pertinent evidence (the record contains
only some sketchy representations by counsel plus unhelpful testi-
mony by Kmart’s CEO, who could not speak for the vendors), and
without making any finding of fact that the disfavored creditors
would gain or come out even. The bankruptcy court’s order de-
clared that the relief Kmart requested—open-ended permission to
pay any debt to any vendor it deemed “critical” in the exercise of
unilateral discretion, provided that the vendor agreed to furnish
goods on “customary trade terms” for the next two years—was “in
the best interests of the Debtors, their estates and their creditors”.
The order did not explain why, nor did it contain any legal analysis,
though it did cite 11 U.S.C. §105(a). (The bankruptcy court issued
two companion orders covering international vendors and liquor
vendors. Analysis of all three orders is the same, so we do not men-
tion these two further.)
Kmart used its authority to pay in full the pre-petition debts to
2,330 suppliers, which collectively received about $300 million. This
came from the $2 billion in new credit (debtor-in-possession or
DIP financing) that the bankruptcy judge authorized, granting the
lenders super-priority in post-petition assets and revenues. See In
re Qualitech Steel Corp., 276 F.3d 245 (7th Cir. 2001). 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, mostly in stock of the reorganized Kmart.
Capital Factors, Inc., appealed the critical-vendors order immedi-
ately after its entry on January 25, 2002. A little more than 14
months later, after all of the critical vendors had been paid and as
Nos. 03-1956 et al. Page 3
Kmart’s plan of reorganization was on the verge of approval, Dis-
trict Judge Grady reversed the order authorizing payment. 291 B.R.
818 (N.D. Ill. 2003). He concluded that neither §105(a) nor a
“doctrine of necessity” supports the orders.
Appellants insist that, by the time Judge Grady acted, it was too
late. Money had changed hands and, we are told, cannot be re-
funded. But why not? Reversing preferential transfers is an ordi-
nary feature of bankruptcy practice, often continuing under a con-
firmed plan of reorganization. See Mellon Bank, N.A. v. Dick Corp.,
351 F.3d 290 (7th Cir. 2003). If the orders in question are invalid,
then the critical vendors have received preferences that Kmart is
entitled to recoup for the benefit of all creditors. Confirmation of a
plan does not stop the administration of the estate, except to the
extent that the plan itself so provides. Compare In re Hovis, No. 02-
2450 (7th Cir. Feb. 2, 2004), with In re UNR Industries, Inc. , 20 F.3d
766 (7th Cir. 1994). Several provisions of the Code do forbid revi-
sion of transactions completed under judicial auspices. For exam-
ple, the DIP financing order, issued contemporaneously with the
critical-vendors order, is sheltered by 11 U.S.C. §364(e): “The re-
versal or modification on appeal of an authorization under this
section to obtain credit or incur debt, or of a grant under this sec-
tion of a priority or a lien, does not affect the validity of any debt so
incurred, or any priority or lien so granted, to an entity that ex-
tended such credit in good faith, whether or not such entity knew
of the pendency of the appeal, unless such authorization and the
incurring of such debt, or the granting of such priority or lien, were
stayed pending appeal.” Nothing comparable anywhere in the
Code covers payments made to pre-existing, unsecured creditors,
whether or not the debtor calls them “critical.” Judges do not in-
vent missing language.
Now it is true that we have recognized the existence of a long-
standing doctrine, reflected in UNR Industries, that detrimental re-
liance comparable to the extension of new credit against a promise
of security, or the purchase of assets in a foreclosure sale, may
make it appropriate for judges to exercise such equitable discretion
as they possess in order to protect those reliance interests. See also
In re Envirodyne Industries, Inc., 29 F.3d 301, 304 (7th Cir. 1994).
Thus once action has been taken to distribute assets under a con-
firmed plan of reorganization, it would take some extraordinary
Nos. 03-1956 et al. Page 4
event to turn back the clock. These appeals, however, do not ques-
tion any distribution under Kmart’s plan; to the contrary, the plan
(which was confirmed after the district court’s decision) provides
that adversary proceedings will be filed to recover the preferences
that the critical vendors have received. No one filed an appeal,
which means that it is appellants in this court that now wage a col-
lateral attack on the plan of reorganization.
Appellants say that we should recognize their reliance interests:
after the order, they continued selling goods and services to Kmart
(doing this was a condition of payment for pre-petition debts).
Continued business relations may or may not be a form of reliance
(that depends on whether the vendors otherwise would have
stopped selling), but they are not detrimental reliance. The vendors
have been paid in full for post-petition goods and services. If Kmart
had become administratively insolvent, and unable to compensate
the vendors for post-petition transactions, then it might make
sense to permit vendors to retain payments under the critical-
vendors order, at least to the extent of the post-petition deficiency.
Because Kmart emerged as an operating business, however, no
such question arises. The vendors have not established that any re-
liance interest—let alone any language in the Code—blocks future
attempts to recover preferential transfers on account of pre-
petition debts.
Handleman Company, which received $49 million as a critical
vendor, makes a different procedural objection: that the district
court’s order does not affect it because Capital Factors’ notice of
appeal did not name Handleman as an appellee. Handleman was
not a “party” in the district court and, consistent with the due
process clause of the fifth amendment, cannot be bound by the
district judge’s decision—or so it says. We permitted Handleman
to intervene in this court. Thus it is a party today and will be bound
by our decision, so it is hard to see why it matters whether the dis-
trict judge’s resolution would have had independent effect.
Notices of appeal in bankruptcy must name “all parties to the
judgment, order, or decree appealed from”. Fed. R. Bankr. P.
8001(a)(2). Handleman was not a “party” to the critical-vendors
order; Kmart was the sole party at the time. Kmart filed an ex parte
application that did not specify any particular creditor. It had noti-
fied only 65 creditors of its impending request, and none of these
Nos. 03-1956 et al. Page 5
was among the 2,000 vendors to be left high and dry. The bank-
ruptcy judge’s order likewise did not identify any creditor that ac-
quired rights, for no creditor acquired rights. All the order did was
authorize Kmart to pay any vendor that Kmart in its discretion
deemed “critical.” The party that Capital Factors had to name thus
was Kmart itself, and this it did. If the lack of personal notice about
the proceedings before the district judge deprived Handleman of
due process, then Kmart’s application to the bankruptcy judge de-
prived about 47,000 unsecured creditors of due process! That
would render the critical-vendors order void, and Handleman
would be worse off—for then it would have to repay the money
even if the order’s entry otherwise would have been lawful. But
there is no constitutional obligation to make every creditor a party
to every contested matter in the bankruptcy. As a rule, a trustee or
debtor in possession represents the interests of many stakeholders.
Kmart vigorously represented the interests of Handleman and the
other vendors Kmart deemed “critical”.
Other creditors must look out for their own interests and inter-
vene if need be—as Handleman could have done had it devoted to
these proceedings the care that a $49 million stake warrants. Han-
dleman will be a party, and receive all the notice that the Constitu-
tion requires, if Kmart initiates a preference-recovery action against
it. As a party in this court, Handleman will not be allowed to con-
test matters resolved here; even the 2,327 critical vendors that are
not parties in this court must accept the precedential effect of our
decision. No rule of law requires personal notice to all entities that
might be affected by the precedential (as opposed to the preclusive)
force of an appellate decision. Today’s opinion affects thousands of
“critical vendors” and other unsecured creditors; decisions by the
Supreme Court may affect millions of persons. Only those persons
who will be formally bound by a decision are entitled to individual
notice, and then only when practical (the lesson of many a class
action, see Mirfasihi v. Fleet Mortgage Corp., No. 03-1069 (7th Cir.
Jan. 29, 2004), slip op. 9–10). So there was no flaw in the notice of
appeal or the district judge’s view that Kmart and Capital Factors
were the only parties to the proceedings.
Thus we arrive at the merits. Section 105(a) allows a bank-
ruptcy court to “issue any order, process, or judgment that is nec-
essary or appropriate to carry out the provisions of” the Code. This
Nos. 03-1956 et al. Page 6
does not create discretion to set aside the Code’s rules about prior-
ity and distribution; the power conferred by §105(a) is one to im-
plement rather than override. See Norwest Bank Worthington v.
Ahlers, 485 U.S. 197, 206 (1988); In re Fesco Plastics Corp., 996 F.2d
152, 154 (7th Cir. 1993). Cf. United States v. Noland, 517 U.S. 535,
542 (1996). Every circuit that has considered the question has held
that this statute does not allow a bankruptcy judge to authorize full
payment of any unsecured debt, unless all unsecured creditors in
the class are paid in full. See In re Oxford Management Inc., 4 F.3d
1329 (5th Cir. 1993); Official Committee of Equity Security Holders
v. Mabey, 832 F.2d 299 (4th Cir. 1987); In re B&W Enterprises, Inc.,
713 F.2d 534 (9th Cir. 1983). We agree with this view of §105. “The
fact that a [bankruptcy] proceeding is equitable does not give the
judge a free-floating discretion to redistribute rights in accordance
with his personal views of justice and fairness, however enlightened
those views may be.” In re Chicago, Milwaukee, St. Paul & Pacific
R.R., 791 F.2d 524, 528 (7th Cir. 1986).
A “doctrine of necessity” is just a fancy name for a power to
depart from the Code. Although courts in the days before bank-
ruptcy law was codified wielded power to reorder priorities and pay
particular creditors in the name of “necessity”—see Miltenberger v.
Logansport Ry., 106 U.S. 286 (1882); Fosdick v. Schall, 99 U.S. 235(1878)—today it is the Code rather than the norms of nineteenth
century railroad reorganizations that must prevail. Miltenberger
and Fosdick predate the first general effort at codification, the
Bankruptcy Act of 1898. Today the Bankruptcy Code of 1978 sup-
plies the rules. Congress did not in terms scuttle old common-law
doctrines, because it did not need to; the Act curtailed, and then
the Code replaced, the entire apparatus. Answers to contemporary
issues must be found within the Code (or legislative halls). Older
doctrines may survive as glosses on ambiguous language enacted in
1978 or later, but not as freestanding entitlements to trump the text.
See, e.g., Lamie v. United States Trustee, No. 02-693 (U.S. Jan. 26,
2004), slip op. 6–7; United States v. Ron Pair Enterprises, Inc., 489
U.S. 235, 242–46 (1989); Bethea v. Robert J. Adams & Associates,
352 F.3d 1125, 1128–29 (7th Cir. 2003). See also Noland (courts
lack authority to subordinate creditors that judges, as opposed to
legislators, believe should be lower in the hierarchy).
Nos. 03-1956 et al. Page 7
So does the Code contain any grant of authority for debtors to
prefer some vendors over others? Many sections require equal
treatment or specify the details of priority when assets are insuffi-
cient to satisfy all claims. E.g., 11 U.S.C. §§507, 1122(a),
1123(a)(4). Appellants rely on 11 U.S.C. §§363(b), 364(b), and
503 as sources of authority for unequal treatment. Section 364(b)
reads: “The court, after notice and a hearing, may authorize the
trustee to obtain unsecured credit or to incur unsecured debt other
than under subsection (a) of this section, allowable under section
503(b)(1) of this title as an administrative expense.” This author-
izes the debtor to obtain credit (as Kmart did) but has nothing to
say about how the money will be disbursed or about priorities
among creditors. To the extent that In re Payless Cashways, Inc.,
268 B.R. 543 (Bankr. W.D. Mo. 2001), and similar decisions, hold
otherwise, they are unpersuasive. Section 503, which deals with
administrative expenses, likewise is irrelevant. Pre-filing debts are
not administrative expenses; they are the antithesis of administra-
tive expenses. Filing a petition for bankruptcy effectively creates
two firms: the debts of the pre-filing entity may be written down so
that the post-filing entity may reorganize and continue in business
if it has a positive cash flow. See Boston & Maine Corp. v. Chicago
Pacific Corp., 785 F.2d 562 (7th Cir. 1986). Treating pre-filing debts
as “administrative” claims against the post-filing entity would im-
pair the ability of bankruptcy law to prevent old debts from sinking
a viable firm.
That leaves §363(b)(1): “The trustee [or debtor in possession],
after notice and a hearing, may use, sell, or lease, other than in the
ordinary course of business, property of the estate.” This is more
promising, for satisfaction of a pre-petition debt in order to keep
“critical” supplies flowing is a use of property other than in the or-
dinary course of administering an estate in bankruptcy. Capital
Factors insists that §363(b)(1) should be limited to the com-
mencement of capital projects, such as building a new plant, rather
than payment of old debts—as paying vendors would be “in the
ordinary course” but for the intervening bankruptcy petition. To
read §363(b)(1) broadly, Capital Factors observes, would be to al-
low a judge to rearrange priorities among creditors (which is what
a critical-vendors order effectively does), even though the Supreme
Court has cautioned against such a step. See United States v. Reor-
ganized CF&I Fabricators of Utah, Inc., 518 U.S. 213 (1996);
Nos. 03-1956 et al. Page 8
Noland, supra. Yet what these decisions principally say is that pri-
orities do not change unless a statute supports that step; and if
§363(b)(1) is such a statute, then there is no insuperable problem.
If the language is too open-ended, that is a problem for the legis-
lature. Nonetheless, it is prudent to read, and use, §363(b)(1) to do
the least damage possible to priorities established by contract and
by other parts of the Bankruptcy Code. We need not decide
whether §363(b)(1) could support payment of some pre-petition
debts, because this order was unsound no matter how one reads
§363(b)(1).
The foundation of a critical-vendors order is the belief that
vendors not paid for prior deliveries will refuse to make new ones.
Without merchandise to sell, a retailer such as Kmart will fold. If
paying the critical vendors would enable a successful reorganiza-
tion and make even the disfavored creditors better off, then all
creditors favor payment whether or not they are designated as
“critical.” This suggests a use of §363(b)(1) similar to the theory
underlying a plan crammed down the throats of an impaired class
of creditors: if the impaired class does at least as well as it would
have under a Chapter 7 liquidation, then it has no legitimate objec-
tion and cannot block the reorganization. See generally Bank of
America v. 203 N. LaSalle St. Partners, 526 U.S. 434 (1999). For the
premise to hold true, however, it is necessary to show not only that
the disfavored creditors will be as well off with reorganization as
with liquidation—a demonstration never attempted in this pro-
ceeding—but also that the supposedly critical vendors would have
ceased deliveries if old debts were left unpaid while the litigation
continued. If vendors will deliver against a promise of current
payment, then a reorganization can be achieved, and all unsecured
creditors will obtain its benefit, without preferring any of the unse-
cured creditors.
Some supposedly critical vendors will continue to do business
with the debtor because they must. They may, for example, have
long term contracts, and the automatic stay prevents these vendors
from walking away as long as the debtor pays for new deliveries.
See 11 U.S.C. §362. Fleming Companies, which received the largest
critical-vendors payment because it sold Kmart between $70 mil-
lion and $100 million of groceries and related goods weekly, was
one of these. No matter how much Fleming would have liked to
Nos. 03-1956 et al. Page 9
dump Kmart, it had no right to do so. It was unnecessary to com-
pensate Fleming for continuing to make deliveries that it was le-
gally required to make. Nor was Fleming likely to walk away even if
it had a legal right to do so. Each new delivery produced a profit; as
long as Kmart continued to pay for new product, why would any
vendor drop the account? That would be a self-inflicted wound. To
abjure new profits because of old debts would be to commit the
sunk-cost fallacy; well-managed businesses are unlikely to do this.
Firms that disdain current profits because of old losses are unlikely
to stay in business. They might as well burn money or drop it into
the ocean. Again Fleming illustrates the point. When Kmart
stopped buying its products after the contract expired, Fleming
collapsed (Kmart had accounted for more than 50% of its business)
and filed its own bankruptcy petition. Fleming was hardly likely to
have quit selling of its own volition, only to expire the sooner.
Doubtless many suppliers fear the prospect of throwing good
money after bad. It therefore may be vital to assure them that a
debtor will pay for new deliveries on a current basis. Providing that
assurance need not, however, entail payment for pre-petition
transactions. Kmart could have paid cash or its equivalent.
(Kmart’s CEO told the bankruptcy judge that COD arrangements
were not part of Kmart’s business plan, as if a litigant’s druthers
could override the rights of third parties.) Cash on the barrelhead
was not the most convenient way, however. Kmart secured a $2
billion line of credit when it entered bankruptcy. Some of that
credit could have been used to assure vendors that payment would
be forthcoming for all post-petition transactions. The easiest way
to do that would have been to put some of the $2 billion behind a
standby letter of credit on which the bankruptcy judge could
authorize unpaid vendors to draw. That would not have changed
the terms on which Kmart and any of its vendors did business; it
just would have demonstrated the certainty of payment. If lenders
are unwilling to issue such a letter of credit (or if they insist on a
letter’s short duration), that would be a compelling market signal
that reorganization is a poor prospect and that the debtor should
be liquidated post haste.
Yet the bankruptcy court did not explore the possibility of us-
ing a letter of credit to assure vendors of payment. The court did
not find that any firm would have ceased doing business with
Nos. 03-1956 et al. Page 10
Kmart if not paid for pre-petition deliveries, and the scant record
would not have supported such a finding had one been made. The
court did not find that discrimination among unsecured creditors
was the only way to facilitate a reorganization. It did not find that
the disfavored creditors were at least as well off as they would have
been had the critical-vendors order not been entered. For all the
millions at stake, this proceeding looks much like the Chapter 13
reorganization that produced In re Crawford, 324 F.3d 539 (7th Cir.
2003). Crawford had wanted to classify his creditors in a way that
would enable him to pay off those debts that would not be dis-
charged, while stiffing the creditors whose debts were discharge-
able. We replied that even though classification (and thus unequal
treatment) is possible for Chapter 13 proceedings, see 11 U.S.C.
§1322(b), the step would be proper only when the record shows
that the classification would produce some benefit for the disfa-
vored creditors. Just so here. Even if §362(b)(1) allows critical-
vendors orders in principle, preferential payments to a class of
creditors are proper only if the record shows the prospect of benefit
to the other creditors. This record does not, so the critical-vendors
order cannot stand.
Affɪʀmed