~ 13 -
The case is remanded for further proceedings consistent with

this opinion.

Date: September 29, 2003

ENTER:

John ¥, Grady, United States "eS Judge



-4-
under a “clearly erroneous” standard and its conclusions of law de

novo. See In re Smith, 286 F.3d 461, 464-65 (7th Cir. 2002); Fed.

R. Bankr. P, 8013.

Capital raises the following issues on appeal: (1) whether 11
U.S.C. § 105(a) or the “doctrine of necessity” provides a
bankruptcy court with either statutory authority or equitable power
to allow the payment of selected prepetition unsecured trade claims
prior to confirmation of a Chapter 11 plan?; (2) whether there was
a sufficient evidentiary basis for the bankruptcy court to allow
payment of certain prepetition claims; and (3) whether state laws
prohibiting liquor wholesalers from selling products to Chapter 11
debtors legally unable to pay their prepetition debt are invalid or
unenforceable to the extent that they conflict with the Bankruptcy
Code.? Kmart raises the additional issue of whether Capital’s
appeals are moot because Kmart has already paid a substantial
portion of the prepetition claims.

A. The Bankrupte urt’s Power Under 105

We first examine the question of whether the bankruptcy court

had the power to authorize the pre-plan payment of prepetition

claims. The court relied on 11 U.S.C, § 105(a) to authorize the

# For convenience, we will refer to the time period prior to confirmation
of a Chapter 11 plan as “pre-plan.”

# Capital also raises what it deems a separate issue of whether “a
bankruptcy court may utilize” § 105(a} or the “doctrine of necessity” “to
circumvent explicit provisions of the Bankruptcy Code.” (Appellant’s Brief at
2.) We view this issue as being part and parcel of the first issue listed supra.



-~9-
paid. Kmart makes much of the fact that Capital did not seek a
stay of the bankruptcy court’s orders. It is highly unlikely,
however, that a motion to stay would have been successful. It
would be inconsistent for the bankruptcy court to enter the orders
on the theory that prompt payments were necessary to keep Kmart
operational, and then turn around and stay those orders.’ In any
event, Capital was not required to seek a stay of the orders in
order to preserve its appellate rights.

Kmart also argues that the appeals are “equitably moot”
because effective relief on appeal has become imprudent and
inequitable. The term “equitable mootness” was “anathematized by
Judge Easterbrook”? in the case of In re UNR Industries, Inc., 20
F.3d 766, 768 (7th Cir. 1994). The Seventh Circuit in UNR
‘“panish[ed} the term ‘equitable mootness’ from the (local)
lexicon,” 20 F.3d at 769, because it is misleading: “[t]here is a
big difference between inability to alter the outcome (real
mootness) and unwillingness to alter the outcome (‘equitable
mootness’).” Id. Nonetheless, the “now nameless doctrine” lives
on and “is perhaps best described as merely an application of the
age-old principle that in formulating equitable relief a court must

consider the effects of the relief on innocent third parties.”

Vv See Charles Jordan Tabb, Emergency Preferential Orders in Bankruptcy
Reorganizations, 65 Am, Bankr. L.J. 75, 108 (1991).

¥ In re Envirodyne Indus,, Inc., 29 F.3d 301, 304 (7th Cir. 1994).



~6-
reorganization,® The doctrine is not codified anywhere in the
Bankruptcy Code, so the only way to apply it is through § 105.
The Seventh Circuit has stated that the grant of equitable
power in § 105 is limited in that it “allows [bankruptcy] courts to
use their equitable powers only as necessary to enforce the
provisions of the Code, not to add on to the Code as they see fit.”
In re Fesco Plastics Corp., 996 F.2d 152, 156 (7th Cir. 1993); see
also Gouveia v. Tazbir, 37 F.3d 295, 300 (7th Cir. 1994) (“The
Supreme Court has taught that any grant of authority given to the
bankruptcy courts under § 105 must be exercised within the confines

of the bankruptcy code.”) (citing Norwest Bank Worthington v.

Ahlers, 485 U.S. 197 (1988)).

The Bankruptcy Code sets forth a priority scheme for the
payment of claims. See 11 U.S.C. §§ 503, 507. The Code does not
carve out priority or administrative expense status for prepetition
general unsecured claims based on the “critical” or “integral”
status of a creditor. But the effect of the bankruptcy court's
orders was to elevate the claims of the “critical” vendors over
those of other unsecured creditors and to subordinate the claims of

non-“critical” unsecured creditors, The bankruptcy court altered

the priority scheme set forth in the Bankruptcy Code.

See 2 William L. Norton, Jr., Norton Bankr. L. & Prac. 2d § 42:11
(Supp. 2002), for a good discussion of the doctrine’s history.



-5-
payments. Section 105(a) addresses the equitable powers of
bankruptcy courts and provides:

The court may issue any order, process, or judgment that

is necessary or appropriate to carry out the provisions

of this title. No provision of this title providing for

the raising of an issue by a party in interest shall be

construed to preclude the court from, sua sponte, taking

any action or making any determination necessary or

appropriate to enforce or implement court orders or

rules, or to prevent an abuse of process.
11 u.8.c. § 105(a). Although the bankruptcy court did not refer
specifically to the equitable “doctrine of necessity” when ruling
on the motions in open court or in its written orders,! Kmart
relies on the doctrine, It is derived from the “necessity of
payment rule,” which was developed and used in railroad
reorganizations “as justification for the payment of pre-petition
debts paid under duress to secure continued supplies or services

essential to the continued operation of the railroad.” B & W

Enters., Inc. v. Goodman Oil Co. (In re B & W Enters., Inc.), 713

F.2d 534, 537 (9th Cir. 1983). The rule has subsequently evolved
into the “doctrine of necessity,” which has been applied in non-
railroad reorganizations to justify the pre-plan payment of
prepetition claims of creditors who threaten to withhold goods or

services believed critical to the debtor’s continued viability and

4 As noted supra, the bankruptcy court did, however, find that the
payments were “necessary,” “integral,” and that there was “good business
justification” for them.



-~e-
of “equity,” especially in light of the Seventh Circuit's
admonition that “[t]he 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 & Pac. R.R. Co., 791 F.2d 524, 528

(7th Cir. 1986).

We acknowledge that the application of the “doctrine of
necessity” through § 105 in this situation is well-intended and may
even have some beneficial results, in that pre-plan payment of
certain prepetition claims allows the debtor to minimize
disruptions in doing business, and thus may further reorganization.
Nevertheless, it is clear that however useful and practical these
payments may appear to bankruptcy courts, they simply are not
authorized by the Bankruptcy Code. Congress has not elected to
codify the doctrine of necessity or otherwise permit pre-plan
payment of prepetition unsecured claims,

Because we hold that the bankruptcy court did not have either
the statutory or equitable power to authorize the pre~plan payment
of prepetition unsecured claims, we need not address the second and
third issues Capital raises on appeal.

B. NEquitable Mootness”

Kmart does not persuade us that Capital’s appeals are moot due

to the fact that the prepetition claims have been substantially



A Wy United States District Court, Northern District of Illinois

Name of Assigned Jur Sittin
ery Magistrate Judge John F. Grady than Assigned Judge
CASE NUMBER 02 C 3178 DATE 9/29/03
CASE Capital Factors, Ine vs. Kmart Corporation
TITLE

{{n the following box (a) indicate the party filing the motion, e.., plaintiff, defendant, 3¢d party plaintiff, and (b) state briefly the nature

MOTION: of the motion being presented,

DOCKET ENTRY;

dy Oo Filed motion of [ use listing in “Motion” box above,]

(2) oO Brief in support of motion due

(3) QO Answer brief to motion duc_____. Reply toanswerbricfdue

4 oO Ruling/Hearingon____setfor__—ut_—

(5) Qo Status hearing[held/continucd to] [set for/re-set for]on__—esetfor at

(6) Qo Pretrial conference(held/continued to] [sct for/re-set for]on__—set fora
(7) oO Trial[set for/re-set for]on at.

(8) Oo {Bench/Jury trial] [Hearing] held/continued to at

(9) Oo This case is dismissed [with/without] prejudice and without costs[by/agreement/pursuant to]

COPRCP4(m) ClLocal Rule 41.1 CUFRCP41(a)(1) C1 FRCP41(a)(2).

(0) «x [Other docket entry] ENTER MEMORANDUM OPINION: The following orders of
the bankruptcy court are reversed: (1) Order Under 11 U.S.C. § 105(a)
Authorizing the Payment of Prepetition Claims of Certain Critical
Trade Vendors; (2) Order Pursuant to 11 U.S.C. §§ 105(a) and 363
Authorizing Payment of Prepetition Obligations Necessary to Obtain
Imported Merchandise; (3) Order Pursuant to 11 U.S.C. §§ 105(a) and
363 Authorizing the Debtors to Honor Reimbursement Obligations to
Issuers of Pre-Petition Letters of Credit Issued for the Benefit of
the Debtors’ Foreign Vendors; and (4) Order Under 11 U.S.C. § 105(a)
Authorizing the Payment of Prepetition Claims of Certain Liquor
Vendors. The case is remanded for further proceedings.

dl) WF [For further detail sec order attached to the original minute order.]
No natives required, advised in open court. * Document
No notices required, Number: :
umber of notices é E
Notices mailed by judge's staff,
ro 1g" 35 9.2003]
Notified counsel by telephone. an iris i a dose .

wv | Docketing to mail notices.

Mail AO 450 form, ee

Copy to judge/magistrate judge.

dove mulled notion

AMM deputy’s
initials



-i1-
such lenders and Kmart” (JPM Brief at 1), has filed a supplemental
brief regarding the Letters of Credit Motion. JPM contends that,
even if the bankruptcy court did not have the authority under § 105
to authorize Kmart to pay the prepetition claims of the issuers of
the letters of credit, the court “properly allowed those payments
[pursuant to § 361 of the Bankruptcy Code] on the basis that such
payments constituted adequate protection for the Issuers’ secured
reimbursement claims under the Letters of Credit.” (JPM Brief at
2.) According to JPM, the issuers had statutory liens in the
documents and the proceeds thereof presented by the foreign vendors
to obtain payment under the letters of credit, and the issuers were
entitled to adequate protection of those liens under § 361 of the
Code.??

In authorizing the payments to the issuers of the letters of
credit, the bankruptcy court did not rely on § 361. We may affirm

the bankruptcy court’s decision on an alternative ground, but that

Lf Section 361 provides:

When adequate protection is required under section 362, 363, or 364
of this title of an interest of an entity in property, such adequate
protection may be provided by--

1) requiring the trustee to make a cash payment or periodic cash
payments to such entity, to the extent that the stay under section
362 of this title, use, sale, or lease under section 363 of this
title, or any grant of a lien under section 364 of this title
results in a decrease in the value of such entity’s interest in such
property;

2) providing to such entity an additional or replacement lien to the
extent that such stay, use, sale, lease, or grant results in a
decrease in the value of such entity’s interest in such property; or
3) granting such other relief, other than entitling such entity to
compensation allowable under section 503(b)(1) of this title as an
administrative expense, as will result in the realization by such
entity of the indubitable equivalent of such entity's interest in
such property.



~10-
Envirodyne, 29 F.3d at 304, The basic questions under the
doctrine, then, are these: is it prudent and fair to undo what the
bankruptcy court did?® See UNR, 20 F.3d at 769; Envirodyne, 29
F.3d at 304.

Kmart argues that we should not reverse the orders allowing
payment of the prepetition claims because the parties receiving the
payments have already acted in reliance on them. As noted supra
note 9, however, this is not a situation where there has been
confirmation of a bankruptcy plan. Accordingly, it is not too late
to order that the monies paid be returned. Kmart also claims that
undoing the bankruptcy court’s orders would “paralyze” Kmart by
forcing it to “undergo the Herculean task of immediately commencing
thousands of lawsuits to collect hundreds of millions of dollars
from thousands of vendors.” (Appellee’s Brief at 45-46.) We are
not persuaded by Kmart’s doomsday speculations. It is not evident
that Kmart will have to sue to recover the payments, and in fact,
Kmart cites no cases indicating that the bankruptcy court would not
have the power to order the return of the monies paid.

c. J.P. Morgan Chase’s Brief
J.P. Morgan Chase (“JPM”), which is an “administrative agent

for the lenders under various pre-petition credit agreements among

* As Capital points out, it is worth noting that most of the cases
addressing or applying the doctrine involved appeals of orders confirming

bankruptcy plans of reorganization. Sea, ¢.q., UNR, 20 F.3d 766; Mac Panel Co.
vw. Virginia Panel Corp., 283 F.3d 622 (4th Cir, 2002). Those cases are

distinguishable from the instant proceeding because there has not yet been a
confirmation of Kmart’s plan.



-7-

There is a split in the courts regarding whether § 105
authorizes bankruptcy courts to permit pre-plan payment of
prepetition unsecured claims. As set forth in Kmart’s briefs, many
bankruptcy courts and a handful of district courts have held that
bankruptcy courts do in fact have this power. See, e.g., In re

Just For Feet, Inc., 242 B.R, 821 (D. Del. 1999); Michigan Bureau

of Workers’ Disability Comp. v. Chateaugay Corp. {In re Chateaugay

Corp.), 80 B.R. 279 (S.D.N.¥. 1987); In re CoServ, L.L.C., 273 B.R.

487 (Bankr. N.D. Tex. 2002); In_re Wehrenberg, Inc., 260 B.R. 468

(Bankr. E.D. Mo, 2001).
On the other hand, as Capital points out, a number of courts
of appeals and a few lower courts have held just the opposite.

See, e.g., Official Comm. of Equity Sec. Holders v. Mabey, 832 F.2d

299 (4th Cir. 1987); B.& WEnters., Inc, vy. Goodman Oil Co. (In re

B& WEnters., Inc.), 713 F.2d 534 (9th Cir. 1983); Chiasson v. J.

Louis Matherne & Assocs. (In re Oxford Mamt. Inc.), 4 F.3d 1329

(Sth Cir, 1993); In re FCX, Inc., 60 B.R. 405 (E.D.N.C. 1986); In

re Timberhouse Post & Beam, Ltd., 196 B.R. 547 (Bankr. D. Mont.

1996).* We agree with the latter courts’ view that we cannot

ignore the Bankruptcy Code’s statutory scheme of priority in favor

¥ Cf. Shapiro v. Saybrook Mfq. Co. (In re Saybrook Mfq Co.), 963 F.2d
1490 (llth Cir. 1992) (bankruptcy court had no authority to allow cross-
collaterization, a method of securing prepetition debt with prepetition and
postpetition collateral); Southern Ry. Co. v. Johnson Bronze Go. (In re Johnson
Bronze Co.), 758 F.2d 138 (3d Cir. 1985) (bankruptcy court had no authority to
grant lien status to a prepetition contractual indemnification claim); Crowe &
Assocs., Inc. v. Bricklavers & Masons Union Local No. 2 (In re Crowe & Assocs
Inc.), 713 F.2d 211, 216 (6th Cir. 1983) (dictum).



~3e

On February 1 and 8, 2002, Kmart filed motions seeking
authority to pay issuers of prepetition letters of credit (the
“Letters of Credit Motion”) and prepetition claims of certain
liquor vendors (the “Liquor Vendors Motion”). On February 13, the
bankruptcy court held a hearing on these motions, heard evidence,
and granted both motions over Capital's objections. Regarding the
Letters of Credit Motion, the court stated:

Because the foreign vendors are integral to the

reorganization of this Debtor and the Court already ruled

on the payment of certain foreign vendors as part of the

critical vendors motions and I believe that this is just

a component of that particular transaction, and further

finding that I may be inconsistent if I do not grant the

relief that is requested here, I am going to go ahead and

sign your order authorizing the reimbursement of the

obligations to the issuers of Letters of Credit.
(Id., Ex, 4B, at 251.) The bankruptcy court also granted the
Liquor Vendors motion, “finding that there [was] a good business
justification for it.” (Id. at 269.) Written orders granting the
motions were entered that same day.

Capital filed notices of appeal from each order, and we

granted Capital’s motion to consolidate the appeals. The parties’

briefing is complete, and we heard oral argument on the appeals as

well.
DISCUSSION
This court has jurisdiction over the instant appeals pursuant
to 28 U.S.C. § 158(a) (1). On appeal from an order of the

bankruptcy court, we review the bankruptcy court’s factual findings



-2-
reorganization, and it invoked the “doctrine of necessity” and 11
U.S.C. § 105(a) for the bankruptcy court’s authority to permit
these payments.

The same day, the bankruptcy court held a hearing and heard
evidence on these motions. Appellant Capital Factors, Inc.
(“Capital”) objected to both motions. (Capital is a factoring
agent’ for a number of Kmart’s apparel suppliers, and it holds
general unsecured claims against the bankruptcy estate of
approximately $20 million.)

Regarding the Critical Vendors Motion, the court stated:

Motions to pay certain critical trade creditors always

present difficult questions for courts. We're seeing

more and more of them, and our problem is that we have to

stretch to find some authority to do them. However, I,

after hearing this testimony and reading the affidavit

[of Charles C, Conaway, Kmart's Chief Executive Officer],

am convinced that Fleming, Handleman and the egg and

dairy vendors~-and I would like a list of the specific

vendors that you would like included in this motion--as

well as the advertising concerns, are necessary to keep

this business going as a going concern.

(App. to Appellee’s Brief, Ex. 4A, at 162.) Accordingly, the
bankruptcy court granted the Critical Vendors Motion. Without
reciting specific findings from the bench, the bankruptcy court
also granted the Foreign Vendors Motion. (Id. at 173.) On January

25, the bankruptcy court entered written orders granting both

motions.

¥ A factoring agent purchases accounts receivable from its customers and
assumes the collection responsibilities. See Mr, Furniture Warchouso, Inc. v.
Barclays Am, /Commercial Inc., 919 F.2d 1517, 1519 (11th Cir. 1990),



02-1264.031-JCD April 8, 2003

IN THE UNITED STATES DISTRICT COURT
FOR THE NORTHERN DISTRICT OF ILLINOIS
EASTERN DIVISION

DOCKETED

CAPITAL FACTORS, INC., SEP 3 9 2003

Appellant,

No. 02 C 1264
(CONSOLIDATED WITH
02 C 1265, 02 C 2086,
02 C 2088, 02 C 3178)

ve

KMART CORPORATION,

Appellee.

MEMORANDUM OPINION

Capital Factors, Inc. appeals from four final orders of the
bankruptcy court that authorized Kmart to pay certain prepetition
obligations. For the reasons explained below, the bankruptcy
court’s orders are reversed.

BACKGROUND

On January 22, 2002, Kmart Corporation and certain of its
domestic subsidiaries and affiliates, debtors and debtors~in-~
possession (collectively, “Kmart”) filed a voluntary petition for
reorganization pursuant to Chapter 11 of the United States
Bankruptcy Code. As part of its “first day motions” filed on that
date, Kmart sought authority to pay prepetition obligations to
certain “critical vendors” (the “Critical Vendors Motion”) and
certain foreign vendors (the “Foreign Vendors Motion”). Kmart
contended that these payments were necessary to maintain

relationships essential to its continued operation and



- 12+
ground must have been adequately presented in the bankruptcy court.

See Anderson v. U.S.F. Logistics (IMC) Inc., 274 F.3d 470, 478

(7th Cir. 2001) (citing Logan v. Caterpillar, Inc,, 246 F.3d 912,

924 (7th Cir. 2001)). Neither Kmart nor the issuers raised the
adequate protection issue at the hearing on the Letters of Credit
Motion. The bankruptcy court was not presented with evidence on
whether the issuers held valid security interests nor whether they
were entitled to adequate protection. There is an insufficient
basis in the record to allow a finding that the payments to the
issuers constituted adequate protection under § 361 of the
Bankruptcy Code.
CONCLUSION

For the foregoing reasons, the following orders of the
bankruptcy court are reversed: (1) Order Under 11 U.S.C. § 105(a)
Authorizing the Payment of Prepetition Claims of Certain Critical
Trade Vendors; (2) Order Pursuant to 11 U.S.C, §§ 105(a) and 363
Authorizing Payment of Prepetition Obligations Necessary to Obtain
Imported Merchandise; (3) Order Pursuant to 11 U.S.C. §§ 105(a) and
363 Authorizing the Debtors to Honor Reimbursement Obligations to
Issuers of Pre-Petition Letters of Credit Issued for the Benefit of
the Debtors’ Foreign Vendors; and (4) Order Under 11 U.S.C. §
105(a) Authorizing the Payment of Prepetition Claims of Certain

Liquor Vendors.