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In re Kmart Corp.

United States Court of Appeals for the Seventh Circuit

January 22, 2004, Argued. ; February 24, 2004, Decided. 1

Nos. 03-1956, 03-1999, 03-2000, 03-2001, 03-2035, 03-2262, 03-2346, 03-2347 &, 03-2348


 [*868]  EASTERBROOK, Circuit Judge. On the first day of its bankruptcy, Kmart sought permission to pay immediately, and in full, the prepetition 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 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-vendors cut off supplies and the business shut down. Putting the proposition in this way implies, however, that the debtor must prove, and not just [**2]  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, 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 disfavored 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  [*869]  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).  [**3]  (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 mention 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 [cent] 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 [**4]  § 105(a) nor a "doctrine of necessity" supports the orders.

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359 F.3d 866 *; 2004 U.S. App. LEXIS 3397 **; 51 Collier Bankr. Cas. 2d (MB) 1076; 42 Bankr. Ct. Dec. 166; Bankr. L. Rep. (CCH) P80,054

In the matter of: KMART CORPORATION, Debtor-Appellant, Additional intervening appellants: KNIGHT-RIDDER, INC.; HANDLEMAN COMPANY; IRVING PULP & PAPER, LIMITED.

Subsequent History: Rehearing denied by In re Kmart Corp., 2004 U.S. App. LEXIS 9050 (7th Cir. Ill., May 6, 2004)

US Supreme Court certiorari denied by, Motion granted by Irving Pulp & Paper, Ltd. v. Capital Factors, Inc., 2004 U.S. LEXIS 7649 (U.S., Nov. 15, 2004)

US Supreme Court certiorari denied by Handleman Co. v. Capital Factors, Inc., 2004 U.S. LEXIS 7528 (U.S., Nov. 15, 2004)

US Supreme Court certiorari denied by Knight-Ridder, Inc. v. Capital Factors, Inc., 2004 U.S. LEXIS 7527 (U.S., Nov. 15, 2004)

Prior History:  [**1]  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.

Capital Factors, Inc. v. Kmart Corp., 2003 U.S. Dist. LEXIS 17437 (N.D. Ill., Sept. 29, 2003)

Disposition: Affirmed.


vendors, critical-vendors, reorganization, notice, unsecured creditor, pre-petition, disfavored, deliveries, authorize, bankruptcy judge, entity, post-petition, transactions, proceedings, orders

Bankruptcy Law, Avoidance, Prepetition Transfers, Preferential Transfers, Plans, Plan Confirmation, Cramdowns, Bankruptcy, Administrative Powers, Postpetition Credit, General Overview, Contracts Law, Consideration, Enforcement of Promises, Governments, Legislation, Interpretation, Contract Formation, Postconfirmation Effects, Procedural Matters, Judicial Review, Bankruptcy Appeals Procedures, Case Administration, Notice, Bankruptcy Court Powers, Claims, Types of Claims, Definitions, Unsecured Priority Claims, Administrative Expenses, Estate Property Lease, Sale & Use, Ordinary Course of Business