Marie Blog Post

By Marie Dickson

Marie Blog Post

          One of the basic tenets of chapter 11 bankruptcy law is that distributions of estate assets normally take place through a Chapter 11 plan, in accordance with the distributional priorities of the Bankruptcy Code.[1] Courts nonetheless will approve “first-day” orders that allow payments of employee’s prepetition wages and to “critical vendors” for goods and services.[2]

          Payment of employees for work they did prior to the bankruptcy may be essential to the debtor’s continued operations because employees quit if they are not paid.  A critical vendor is typically a sole supplier or service provider of an essential component of the debtor’s manufacturing operations.  The critical vendor may refuse to provide the debtor with the essential good or service post-bankruptcy if it is not paid what it was owed when the case filed.

          But a debtor once it has filed its Chapter 11 reorganization petition generally is prohibited by bankruptcy law from paying prepetition claims.  Because of this, a bankruptcy court must enter an order authorizing these payments of the pre-bankruptcy claims of employees, critical vendors, and others who are essential to the continued operations and reorganization of the debtor’s business.

          The United States Supreme Court first articulated the “necessity of payment doctrine” over a century ago, not under bankruptcy law, but in an equity receivership involving an insolvent railroad. The Supreme Court stated, “many circumstances may exist which may make it necessary and indispensable to the business of the road and the preservation of the property, for the receiver to pay pre-existing debts…”[3] Many courts, including those in the Third Circuit, have applied the necessity of payment doctrine to bankruptcy cases, though nothing in the Bankruptcy Code specifically authorizes it.

          Under the “necessity of payment doctrine,” a court may, pursuant to the section of the Bankruptcy Code governing power of the court, authorize payment of prepetition claims when such payment is necessary for the debtor’s survival during Chapter 11.[4] To invoke the necessity of payment doctrine, a debtor must show “payment of the pre-petition claims is critical to the debtor’s reorganization.”[5]

          The next step is authorizing payment. On a pre-petition claim, the debtor must prove payment is necessary to the survival of a debtor and “essential to the continued operation of the debtor” in the Chapter 11 reorganization.[6] Section 105(a) often is cited as the statutory basis for the payment of prepetition claims.[7] Section 105(a) states:

[T]he court may issue any order, process, or judgment that is necessary or appropriate to carry out 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 abuse of process.[8]

The courts within the Third Circuit generally rule favorably on wage and critical vendor motions without daunting requirements for the debtor to satisfy.[9] The rule is similarly applied in the Second Circuit.[10]

            Even within these circuits, though, courts have denied a debtor’s request to pay prepetition critical vendor claims on numerous occasions. One of these courts, in Pennsylvania, denied such a motion in the GVM case.[11] The bankruptcy court in GVM criticized the critical vendor payment claim as a carved-out exception to the hierarchy of priority claims, not mentioned in the Bankruptcy Code.[12]

            Other circuits have been more critical of the rule. From the Seventh Circuit, the Kmart case characterized the doctrine of necessity as “a fancy name for power to depart from the code.”[13] The court rejected several statutory provisions as providing sufficient authority to pay prepetition claims early in the case.  Section 364(b), the court reasoned, authorizes “the debtor to obtain credit but has nothing to say about how the money will be disbursed or about priorities among creditors.”[14] The Seventh Circuit in Kmart similarly rejected Section 363(b) (authorizing the use of estate property), Section 105(a), and the doctrine of necessity. The court also criticized the bankruptcy court’s factual findings, specifically stating that the vendors were not likely to walk away, alternatives were not explored by the debtor, and there was an insufficient benefit to other creditors.[15]

            There are various positives in paying employees and critical vendors. First, it enables a successful reorganization. Second, it puts even the disfavored creditors in a better and stronger position because it preserves the operating business, which is worth more than it would be if liquidated.[16] It was Delaware’s bankruptcy judges, beginning with the first, Helen S. Balick, who recognized that predictable “first day” relief in the form of paying employees and critical vendors helps to stabilize a Chapter 11 debtor’s business and to maximize value.  Even the Supreme Court has come to recognize this.[17]

[1] Czyzewski v. Jevic Holding Corp., 137 S. Ct. 973, 983 (2017).

[2] Id. at 985.

[3] Miltenberger v. Logansport, 106 U.S. 286, 311 (1882).

[4] In re Just For Fleet, Inc., 242 B.R. 821, 825 (Bankr. D. Del. 2003).

[5] Id.

[6] Id.

[7] 11 U.S.C. § 105(a) (1999); Just For Fleet, 242 B.R. at 825.

[8] § 105(a).

[9] Just For Fleet, 242 B.R. at 825.

[10] In re Windstream Holdings, Inc., 614 B.R. 441, 446 (S.D.N.Y. 2020).

[11] In re GVM, Inc., 606 B.R. 220 (Bankr. M.D. Pa. Sept. 6, 2019).

[12] GVM, 606 B.R. at 227.

[13] In re Kmart Corp., 359 F.3d 866, 872 (7th Cir. 2004).

[14] 11 U.S.C. § 364(b) (1999).

[15] Kmart, 359 F.3d at 871.

[16] See § 363(b); see also Kmart Corp., 359 F.3d at 872.

[17] Czyzewski, 137 S. Ct. at 985.