FIRST DAY ORDERS -- CRITICAL VENDOR ORDERS AFTER KMART

By Myles Alderman

With the commencement of a Chapter 11 reorganization comes the automatic stay and also a prohibition of the debtor's use of cash collateral, incurring of new debt, or activity outside the ordinary course without appropriate court orders.

Operation of the debtor's business, therefore, requires a number of orders at the outset of the case -- these are called the First Day Orders. First Day Orders commonly include orders allowing for: Payment of taxes; Payment of pre-petition payroll; The Use of Cash Collateral; and/or Debtor-in-Possession financing.

During the past decade we have seen "Critical Vendor Orders" added to the list of common First Day Orders. Critical Vendor Orders are orders that allow a debtor to pay the pre-petition claim of an unsecured creditor while other creditors are not being paid. The rationale behind the original Critical Vendor Orders was that one or more vendors who supplied products or services that were essential to the Debtor's reorganization would be unable to continue to supply the product or service without an immediate payment. The theory is that if the payment to a vendor that would otherwise fail, would allow the supply of the product that would allow the reorganization of the debtor and therefore allow all creditors to receive more than they would if the debtor failed, then the court should authorize payment to the Critical Vendor.

In the Chapter 11's of Kmart and Fleming the courts granted First Day Orders that included "Critical Vendor Order." Kmart's chapter 11 counsel argued that suppliers might refuse to ship to the debtor without special protection and that without the products that customers expected the debtor would be unable to carry on and all creditors would be harmed. Kmart's counsel further argued that the protection that it needed to afford these vendors was payment in full of prepetition claims.

Without requiring any notice or opportunity to be heard for creditors that would not be favored, without evidence that any "critical vendors" would refuse to ship (or be rendered unable to ship) without the proposed order and without any finding that the critical vendor order would result in unfavored creditors receiving more (or at least no less than if the order was not entered) the bankruptcy court granted a critical vendor order that allowed the debtor to pay those vendors that it deemed critical.

Unlike the manufacturing cases, where the debtors sought to pay a small number of vendors so that critical components for products in production could be completed and sold, in Kmart the debtor selected 2,330 of its 4,000 vendors as "critical vendors" to be paid in full: Paying pre-petition claims of approximately $300 million -- Not an insignificant portion of the $2 billion of DIP financing available. By comparison the Chapter 11 plan proposed by Kmart offered the unsecured creditors, including the 2,000 vendors who were not critical vendors, approximately 10 cents on the dollar.

With the Kmart plan on the verge of confirmation (more than 14 months after the payments had been made) the District Court reversed the Critical Vendor Order, subjecting the 2,300 vendors to claims to disgorge the payments they had received as preferential transfers. An appeal was taken.

In affirming the District Court's decision, the Court of Appeals reasoned that if vendors had shipped in reliance of a promise of payments that were not made they might have had a detrimental reliance argument, but that no such argument could be made in the Kmart case because each vendor was paid in full for its post-petition shipments.

The court further found unpersuasive arguments that payment of pre-petition obligations to critical vendors was essential to maintain the flow of product. The court noted that some of these vendors had contracts that required continued shipments and that others would ship because each new delivery produced new profit: "as long as Kmart continued to pay for new product, why would any vendor drop the account?"

The court concluded that payment of pre-petition obligations was not the appropriate way to assure payment of post-petition obligations, suggesting that the acquisition of letters of credit to guarantee payment for post-petition shipments would have been more appropriate.

We expect that critical vendor orders will still be available under appropriate circumstances. However, before a motion seeking such an order is filed counsel for the critical vendor and/or debtor's counsel should compile the evidence necessary to build a substantial record for the critical vendor order.

The author served as lead bankruptcy counsel to terminated salaried employees in the consolidated Chapter 11 reorganization cases of the Fleming Companies - Fleming sold between $70 million and $100 million of groceries and goods to Kmart each week during Kmart's Chapter 11 and was the recipient of the largest critical vendor payment.

TECHNOLOGY AND THE LAW

Lost Database Is Not Insured

"If you can't reach out and touch it, it is not insured." That was the gist of a court's ruling in a lawsuit brought by a company that lost a large amount of electronically stored data when an employee inadvertently pressed the "delete" key on a keyboard. The company looked to its insurer to cover the expenses for restoring the data and to recover lost income caused by the disruption. The insurer denied coverage on the basis of policy language that limited coverage to a "direct physical loss of or damage to" covered property.

The language from the policy was meant to be interpreted in its ordinary and popular sense. Thus, "physical" means "tangible" or capable of being touched. The information in a computerized database, in and of itself, has no material or tangible existence, unlike a storage medium for information, such as a disk, tape, or even papers in a file cabinet. The court concluded that when the employee sent the data into thin air with an unintended keystroke, there was no direct physical loss within the meaning of the insurance policy. (The court distinguished this case from another case in which the loss of a computer tape and the data on it were covered under a policy covering "physical injury or destruction of tangible property.")

Recognizing that the dictionary was not on its side, the company that lost its data also argued that public policy should weigh heavily in favor of insurance coverage. After all, loss of information in the same manner as occurred in this case is common, and our economy unquestionably is highly dependent on computers and the intangible information that they contain. However, the court declined to use public policy as an "interpretive aid." There are plenty of useful legal principles for construing insurance contracts, but using public policy to redefine the scope of coverage agreed to by parties to a contract is not one of them. The lesson: Questions of insurance coverage are to be answered solely in the language of the policies and, therefore, careful drafting of policy language is critical.

Got a Gripe? Start a Website

Joseph was planning to buy a new house from a builder until he came to the conclusion that the builder's sales representative had misled him about the availability of a particular model. In an earlier time, he might have been content to vent to a sympathetic neighbor across his backyard fence, but this is the age of cyberspace. Joseph registered an Internet name that was very similar to that of the builder and then created a website as a forum for relating the reasons for his frustration with the builder. He included a disclaimer making it clear that visitors were not on the builder's website. There was no charge to access the site and the site contained no paid advertisements. Once in a while, an e-mail intended for the builder came to Joseph's site, but he promptly forwarded it to the builder.

Also on the website was something Joseph called the "Treasure Chest," a place where readers could exchange information about contractors and tradespeople who had done good work. During the entire time the site was up and running, only one person was mentioned in the Treasure Chest. Although it was nearly empty, the Treasure Chest prompted the builder to sue Joseph under the federal Anti-Cybersquatting Consumer Protection Act (ACPA).

The ACPA only applies to someone who, with "a bad-faith intent to profit," registers or uses a domain name that is identical or confusingly similar to that owned by someone else. Everyone agreed that the part of Joseph's website in which he aired his own complaints against the builder had no profit motive or commercial aspects, but the builder tried to argue that the Treasure Chest was a mingling of commercial activities with personal gripes.

A federal court ruled in favor of Joseph. The facts of the case did not amount to the conduct that the ACPA was meant to address, that is, setting up a business whose sole purpose is to register domain names that closely resemble the names of established businesses, and then attempting to sell the names to those businesses. The fact that Joseph meant to use the Treasure Chest to draw more people to his site to read his story did not convert the site into a commercial undertaking. He took no money either for being listed on the site or for viewing it, and the absence of paid advertising or links to other sites belied any profit motive. The website, especially with its very similar name, was no doubt a source of annoyance to the builder, but it was not a source of damages under the ACPA.

IRS GETS TOUGH ON ESTATE TAX FRAUD

Prosecutions for filing a false Form 706, the federal estate tax return, have been rare. Recently, a federal prosecutor announced a guilty plea by an individual charged with estate tax fraud. The guilty plea may well be a harbinger of a new "get tough" policy by the IRS in an area that up until now has not had a reputation for vigorous criminal enforcement.

The defendant in this case was the executor of her mother's estate. She admitted that she intentionally filed a Form 706 that omitted assets worth about $400,000 that should have been included in the estate. The executor could face a term of imprisonment, followed by a term of supervised release, and a large fine.

Individuals who stand to be affected by the new emphasis from the IRS on using a carrot and a stick include executors, tax return preparers, and essentially anyone responsible for the completeness and accuracy of an estate tax return. It is important to remember that old income tax returns and other documents that the IRS can obtain in an audit often will allow it to discover assets that have gone unreported. The recently publicized guilty plea by an executor is a not-very-subtle warning by the IRS that estate tax fraud can have consequences beyond dollars and cents.

CASES OF INTEREST

* Failure to pay for necessary maintenance, or to offer adequate protection to secured creditor, provided sufficient cause for relief from stay to permit recovery of commercial vessels. In re Balco Equities, Ltd, Inc.

* Stalking Horse Protected at Beef Plant: Break-up Fees of 3.2% deemed appropriate for unsuccessful bidder, whose bid for unexpired lease was used as stalking horse. In re Tama Beef Packing, Inc.

* Filing a proof of claim on behalf of partnership found to be insufficient to preserve the claim of the partnership's partner. In re U. S. Office Products Co., Securities Litigation.

* Delay-in-enforcement clause of mortgage designed to waive statute of limitations held to be invalid as against public policy. Haggerty v. Williams.

* Governmental entity may take property that it polluted via condemnation and value property in its contaminated state, when property owner fails to prove diminution in value was caused by that contamination. Albahary v. City of Bristol