Seventh Circuit Rejects The Doctrine Of Necessity

"First day" motions accompanying a chapter 11 debtor's bankruptcy petition routinely include an application for authority to pay the pre-bankruptcy claims of vendors and other creditors without whom the debtor could not continue to operate its business. Many bankruptcy judges grant such "critical vendor" motions by relying upon a principle commonly referred to as the "necessity of payment" rule or "the doctrine of necessity." Developed in connection with railroad reorganizations under the Railway Labor Act (a predecessor statute to the Bankruptcy Code), the doctrine was intended to ensure the continued delivery of supplies or services considered essential to the reorganization efforts of railways. It provided that current and necessary operating expenses incurred within six months of the filing of a railroad reorganization case would be entitled to priority in payment over the claims of other general unsecured creditors.

The problem is that the rule, which is now codified in section 1171(b) of the Bankruptcy Code, only applies to railroad bankruptcies. In other reorganizations, the Bankruptcy Code contemplates that claims asserted by all unsecured pre-petition creditors will be satisfied, in whole or in part, at the conclusion of a chapter 11 case in accordance with the terms of a confirmed plan of reorganization. This is in keeping with one of the Code's primary objectives equality of distribution among similarly situated creditors. Payment to creditors, whether "critical" or not, at the outset of a case is clearly inconsistent with this objective. It alters the priority scheme for unsecured claims set forth in the Bankruptcy Code and (perhaps) unfairly prefers a handful of unsecured creditors over those forced to wait until the end of the case.

Turmoil In The Courts

Undaunted by the absence of express authority, many bankruptcy courts justify deploying the doctrine as an exercise of their broad powers as courts of equity under section 105(a) of the Bankruptcy Code. That section provides that "[t]he court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of" the Bankruptcy

Code. Recognizing that the success of a chapter 11 reorganization hinges in large part on the debtor's ability to avoid, as nearly as possible, significant disruption in its business operations, these courts authorize the debtor to pay the claims of pre-petition vendors at the outset of a case, so long as the debtor demonstrates that a vendor is "critical" and the payment is necessary.

Unfortunately, no less than five federal Circuit Courts of Appeal have either held or expressed the view that neither the doctrine of necessity nor section 105(a) authorizes the payment of pre-petition claims outside of a plan of reorganization. The Ninth Circuit was the first to do so in In re B & W Enterprises Inc., where it ruled that the doctrine of neces- Inc sity is confined to railroad cases, observing that it is "unwise to tamper with the statutory priority scheme devised by Congress." That same year, the Sixth Circuit noted (but did not rule) in Crowe & Associates Inc. v. Bricklayers & Masons Union Local No. 2 (In re Crowe & Associates, Inc.), that a Inc.) bankruptcy court...