Kmart and Beyond: A "Critical" Look atCritical Vendor Orders and theDoctrine of Necessity

I. IntroductionPhone calls like the one following take place on a regular basis between unsecured vendors and debtor's counsel in large Chapter 11 reorganizations."Are we on the list?""No.""Will you put us on the list?""No.""What can we do to be put on the list?""Maybe if you would stop calling!"The unsecured vendors are asking the debtor's counsel to place them on the "critical vendor" list.1 Pending court approval, the critical vendors will receive either partial or full payment of their pre-petition claims against the debtor in exchange for an agreement to continue to sell to the debtor on standard credit terms.2 The other unsecured creditors will likely be paid a fraction of the value of their claims-around 5% to 10% in a typical case.3Critical vendor orders have been attacked on several grounds including a perceived lack of legal authority for such court orders.4 In In re Kmart Corp.,5 the Seventh Circuit shocked the bankruptcy world by nearly undoing the statutory framework supporting critical vendor orders.6 The Seventh Circuit held that section 105(a)7 of the Bankruptcy Code and the doctrine of necessity8 did not provide the necessary authority for critical vendor orders. The court suggested that section 363(b) might be sufficient to authorize the practice, though it explicitly declined to answer that question because the evidentiary record was incomplete.9 The Supreme Court declined to hear the case,10 leaving the circuits in disagreement over whether the Code currently authorizes critical vendor orders.11Before Kmart, courts that were willing to authorize critical vendor orders often relied on the doctrine of necessity.12 The doctrine of necessity allows a trustee or debtor-in-possession to pay the pre-petition debts of certain vendors who threaten to disrupt the debtor's reorganization by withholding critical goods and services until paid their pre-petition debts.13 The doctrine of necessity grew out of the necessity of payment rule, a common law doctrine predating both the Bankruptcy Act of 1898 and the Bankruptcy Code of 1978.14 Courts have disagreed whether the doctrine survived both enactments and, if so, in what form.15 To authorize critical vendor orders, bankruptcy courts have also relied on their general equitable powers under section 105,16 in addition to Sections 363(b), 364, and 549(a).17 After the Seventh Circuit dealt a blow to Section 105 in Kmart, section 363(b) emerged as the strongest candidate to replace section 105 as statutory authority for critical vendor orders.18Once a rare phenomenon, critical vendor orders have increasingly become standard operating procedure in large Chapter 11 cases.19 Aside from the question of their legality, courts and commentators have also criticized critical vendor orders for being overused and for unfairly favoring "critical" unsecured vendors at the expense of the noncritical unsecured vendors.20 Additionally, critical vendor orders have been attacked as impinging on the "due process" rights of affected creditors.21 Some commentators have called for a blanket prohibition against critical vendor orders.22 Equally adamant, proponents of the practice maintain that detractors do not understand the "practical implications" that would flow if critical vendor orders were denied altogether.23The scope and purpose of this Note is a bit unusual and needs to be explained. Ultimately, this Note does not stake out a position on whether section 363 is sufficient to authorize critical vendor orders, but instead weighs the arguments for and against that section.24 Recognizing, however, that critical vendor orders are currently permitted in several jurisdictions, it seeks to provide guidance to courts and practitioners regarding the limited circumstances under which such orders should be issued-at least until the Supreme Court or Congress speaks otherwise. This Note argues that the adoption of a heightened evidentiary standard by courts currently approving critical vendor orders will reduce at least some of the unfairness associated with such orders. …