## Facts

- Kmart Corporation and affiliates filed for Chapter 11 reorganization and sought, on the petition date, authority to pay selected “critical vendors” in full on their pre-petition unsecured claims.
- Kmart asserted that immediate full payment was needed to ensure continued supply of merchandise and to avoid harm to the estate.
- The bankruptcy court entered a first-day “critical-vendors” order granting Kmart open-ended authority to pay any vendor it unilaterally deemed “critical,” conditioned on the vendor’s agreement to continue supplying Kmart on customary trade terms for two years.
- The order was entered without notice to disfavored unsecured creditors, without meaningful evidentiary support, and without factual findings that the payments would benefit (or at least not harm) other unsecured creditors.
- Using debtor-in-possession financing, Kmart paid approximately $300 million to 2,330 “critical” suppliers in full, while more than 2,000 other vendors and roughly 43,000 other unsecured creditors received about 10 cents on the dollar.
- A noncritical creditor appealed; the district court reversed, rejecting reliance on 11 U.S.C. § 105(a) and a freestanding “doctrine of necessity,” and the matter proceeded to the Seventh Circuit on consolidated appeals.

## Issues

1. Whether the Bankruptcy Code authorizes a bankruptcy court to permit full payment of selected pre-petition unsecured claims to “critical vendors” while other unsecured creditors of the same class receive substantially less.
2. Whether 11 U.S.C. § 105(a), 11 U.S.C. § 363(b), or a “doctrine of necessity” can support such payments consistent with the Code’s priority and distribution scheme.
3. What evidentiary and factual findings are required to justify any selective payment of pre-petition unsecured claims.
4. What remedial steps are appropriate when such payments have already been made pursuant to an improper order.

## Decision

- The Seventh Circuit affirmed the district court’s reversal and vacated the critical-vendor order on this record.
- The court held that § 105(a) does not permit a bankruptcy court to override the Code’s priority and equality-of-distribution requirements.
- The court rejected a freestanding “doctrine of necessity” as an independent source of authority under the current Bankruptcy Code.
- The court declined to hold that critical-vendor payments are always impermissible, but required a strict, evidence-based showing that the payments would leave remaining unsecured creditors better off (or at least no worse off).
- The court remanded for further proceedings to determine, creditor-by-creditor or by appropriate grouping, whether any payments could be justified and whether recovery, avoidance, or equitable adjustment was warranted.

## Legal Principles

- Section 105(a) authorizes orders that carry out the Code’s provisions; it does not create substantive rights or permit courts to disregard explicit statutory distribution and priority rules.
- Preferential payment of some general unsecured pre-petition claims over others in the same class is presumptively improper absent a Code-based justification and proof that the transaction increases value available to the disfavored creditors.
- Any approval of selective payment requires proof (not allegations) that: (a) absent immediate full payment the vendors would cease dealing with the debtor, and (b) the resulting continuation of trade produces a net benefit to remaining creditors, or at least does not leave them worse off.
- Business justifications for maintaining supply relationships do not, by themselves, justify paying old debts in full where less discriminatory mechanisms can secure post-petition performance.
- When improper critical-vendor payments have been made, the bankruptcy court must address consequences through fact-specific application of avoidance, restitution, and equitable doctrines rather than assuming either automatic validation or automatic clawback.

## Conclusion

The Seventh Circuit vacated Kmart’s first-day critical-vendor order because it lacked a valid statutory basis and was unsupported by evidence or findings that preferential payments would benefit other unsecured creditors; it remanded for a fact-driven determination of whether any payments could be justified and what recovery or equitable relief should follow.


In re Kmart Corp., 359 F.3d 866 (7th Cir. 2004)