Kmart Coporation v. Capital Factors Inc

In the
United States Court of Appeals
For the Seventh Circuit
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Nos. 03-1956, 03-1999, 03-2000, 03-2001, 03-2035,
03-2262, 03-2346, 03-2347 & 03-2348
In the matter of:
KMART CORPORATION,
Debtor-Appellant,
Additional intervening appellants:
KNIGHT-RIDDER, INC.; HANDLEMAN COMPANY; IRVING
PULP & PAPER, LIMITED.
____________
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.
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ARGUED JANUARY 22, 2004—DECIDED FEBRUARY 24, 2004
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Before EASTERBROOK, MANION, and ROVNER, Circuit
Judges.
EASTERBROOK, 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 sup-
2 Nos. 03-1956, et al.
pliers may be unwilling to do business with a customer that
is behind in payment, and, if it cannot obtain the mer-
chandise 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 payment to critical vendors thus could in
principle make even the disfavored 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 ven-
dors cut off supplies and the business shut down. Putting
the proposition in this way implies, however, that the deb-
tor 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 transac-
tions with the favored vendors to provide some residual
benefit to the remaining, disfavored 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 dis-
favored creditors, without receiving any pertinent evidence
(the record contains only some sketchy representations by
counsel plus unhelpful testimony 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 declared 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 com-
panion orders covering international vendors and liquor
vendors. Analysis of all three orders is the same, so we do
not mention these two further.)
Nos. 03-1956, et al. 3
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 immediately 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 Kmart’s
plan of reorganization was on the verge of approval, District
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 refunded. But why not? Reversing preferential
transfers is an ordinary feature of bankruptcy practice,
often continuing under a confirmed 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 Indus-
tries, Inc., 20 F.3d 766 (7th Cir. 1994). Several provisions of
the Code do forbid revision of transactions completed under
judicial auspices. For example, the DIP financing order,
issued contemporaneously with the critical-vendors order,
is sheltered by 11 U.S.C. §364(e): “The reversal or modifica-
tion on appeal of an authorization under this section to
4 Nos. 03-1956, et al.
obtain credit or incur debt, or of a grant under this section
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 extended 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 grant-
ing 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 invent
missing language.
Now it is true that we have recognized the existence
of a longstanding doctrine, reflected in UNR Industries,
that detrimental reliance 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 pos-
sess 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 confirmed plan of reorganization, it would take
some extraordinary event to turn back the clock. These
appeals, however, do not question any distribution under
Kmart’s plan; to the contrary, the plan (which was con-
firmed after the district court’s decision) provides that ad-
versary 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 collateral 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
Nos. 03-1956, et al. 5
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 reliance 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 district 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 notified only 65 creditors of its
impending request, and none of these was among the 2,000
vendors to be left high and dry. The bankruptcy judge’s
order likewise did not identify any creditor that acquired
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
6 Nos. 03-1956, et al.
lack of personal notice about the proceedings before the
district judge deprived Handleman of due process, then
Kmart’s application to the bankruptcy judge deprived 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
intervene if need be—as Handleman could have done had
it devoted to these proceedings the care that a $49 million
stake warrants. Handleman will be a party, and receive
all the notice that the Constitution requires, if Kmart
initiates a preference-recovery action against it. As a
party in this court, Handleman will not be allowed to
contest matters resolved here; even the 2,327 critical ven-
dors 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.
Nos. 03-1956, et al. 7
Thus we arrive at the merits. Section 105(a) allows a
bankruptcy court to “issue any order, process, or judgment
that is necessary or appropriate to carry out the provisions
of” the Code. This does not create discretion to set aside the
Code’s rules about priority and distribution; the power
conferred by §105(a) is one to implement rather than over-
ride. 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 bank-
ruptcy 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-float-
ing 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 bankruptcy 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 supplies 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
8 Nos. 03-1956, et al.
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).
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 insufficient 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
authorizes 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 adminis-
trative 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 “administra-
Nos. 03-1956, et al. 9
tive” claims against the post-filing entity would impair the
ability of bankruptcy law to prevent old debts from sinking
a viable firm.
That leaves §363(b)(1): “The trustee [or debtor in posses-
sion], 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 ordinary course of
administering an estate in bankruptcy. Capital Factors
insists that §363(b)(1) should be limited to the commence-
ment 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 bank-
ruptcy petition. To read §363(b)(1) broadly, Capital Factors
observes, would be to allow 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.
Reorganized CF&I Fabricators of Utah, Inc., 518 U.S. 213(1996); Noland, supra. Yet what these decisions principally
say is that priorities do not change unless a statute sup-
ports 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 legislature. Nonethe-
less, 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 reorganization and make even the
10 Nos. 03-1956, et al.
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 un-
derlying 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 objection 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 proceeding—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 reorganiza-
tion can be achieved, and all unsecured creditors will obtain
its benefit, without preferring any of the unsecured credi-
tors.
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 million and
$100 million of groceries and related goods weekly, was one
of these. No matter how much Fleming would have liked to
dump Kmart, it had no right to do so. It was unnecessary to
compensate Fleming for continuing to make deliveries that
it was legally 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
Nos. 03-1956, et al. 11
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 throw-
ing 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 transac-
tions. 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
using a letter of credit to assure vendors of payment. The
court did not find that any firm would have ceased doing
12 Nos. 03-1956, et al.
business with 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 discharged,
while stiffing the creditors whose debts were dischargeable.
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 disfavored creditors. Just so here. Even if
§363(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.
AFFIRMED
Nos. 03-1956, et al. 13
A true Copy:
Teste:
________________________________
Clerk of the United States Court of
Appeals for the Seventh Circuit
USCA-02-C-0072—3-2-04