Once upon a time, bankruptcy courts — like the one overseeing Kmart’s chapter 11 case in late 2002 — routinely entered orders (like these) granting the debtor “open-ended permission to pay any debt to any vendor deemed ‘critical’ in the exercise of unilateral discretion, provided that the vendor agreed to furnish goods on ‘customary trade terms’ for the next [several] years.”
This preference of one creditor group over another (in Kmart’s case amounting to over $300 million in preferential postpetition payments to about 2330 so-called “critical” vendors) irked one small band of excluded vendors and creditors enough that they appealed the bankruptcy court’s decision…and won! In re Kmart Corp., 359 F.2d 866 (7th Cir. 2004) (pdf).
In striking down these payments, the 7th Circuit’s Judge Easterbrook took direct aim at the use of Bankruptcy Code section 105(a) (which allows a bankruptcy to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of” the Bankruptcy Code) to justify such preferential payments through incorporation of the old “necessity” doctrine. He wrote:

[Bankruptcy Code section 105] 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 override. 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. 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.” [Citation omitted.]
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”-today it is the Code rather than the norms of nineteenth century railroad reorganizations that must prevail. [Those court decisions] 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 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. (Citations omitted)

Even before the 7th Circuit issued its decision upholding the district court’s reversal (pdf) of Judge Sonderby’s “first-day” order approving the “critical vendor” payments, Kmart filed a host of short, nearly identical two-count complaints (like this) against hundreds of entities that received the challenged payments. Count I of these complaints sought avoidance of the payments under Code sections 549 (dealing with avoidable postpetition transfers) and 550. Alternatively, Count II sought recovery under Section 105, the bankruptcy lawyer’s refuge of last resort.
In a wide-ranging, 62 page unpublished opinion, Judge Sonderby denied the creditors’ motion to dismiss Count I, but granted the motion to dismiss Count II. In so doing, the opinion —

  • details the complex procedural history of the case, including the quick thinking employed by the litigants when the district court’s bombshell reversal came down a mere two days before the start of Kmart’s confirmation hearing (pp. 2-13);
  • rejects the movants’ “plain meaning” arguments that recovery should be denied under Code section 549 because the Court had previously authorized such payments (pp. 13-24);
  • notes the banishment by the 7th Circuit of the term “equitable mootness” from the local lexicon (pp. 20-21);
  • dissects when a “private right of action” arises in the bankruptcy context (such as “in connection with alleged violations of the discharge injunction and the filing of inflated secured claims”), and concludes that no such “separate and independent action exists under §105(a)” (pp. 24-33);
  • reviews at length the doctrine of judicial estoppel and its inapplicability to this case, finding not only that Kmart was not “exploiting” the 7th Circuit’s reversal of the critical vendor order, but that “application of the doctrine under the circumstances of this case would itself amount to [] a perversion [of the doctrine of judicial estoppel]” (pp. 33-48);
  • affirms the adequacy of provisions in the confirmed plan purporting to retain these avoidance actions, even though the pre-confirmation plan modifications were made without attempting to resolicit votes on the plan (pp. 48-58);
  • and

  • punts the remaining arguments, including detrimental reliance, equitable estoppel, and recoupment, as “fact-intensive defenses inappropriate for disposition at this time” (pp. 58-61).

Judge Sonderby obviously has long ruminated about the mess spawned by the reversal of her “critical vendor” order. Now, in an unpublished decision, she has given us much to ruminate about too.
© Steve Jakubowski 2006