Tuesday, July 01, 2008

Doctrine of Necessity

Many of our commercial bankruptcy clients that supply goods to Debtors have asked us about the Doctrine of Necessity, which permits creditors to be paid on pre-petition debts after a bankruptcy filing. The Doctrine is found in the Bankruptcy Code at 11 USC §105(a), which permits the court to "issue any order…that is necessary or appropriate to carry out the provisions of [the Bankruptcy Code]." In the late 19th century, the Doctrine was applied at common law in railroad reorganizations by judges who reordered priorities so that certain creditors would be paid in the name of "necessity."

Today, Section 105 of the Bankruptcy Code does not allow Judges to set aside the Code's priority rules. The rule in present-day Courts prohibits payments to selected unsecured creditors unless all unsecured creditors are paid, but exceptions to this rule exist depending on the circumstances. One exception is where the non-payment of an unsecured pre-bankruptcy filing claim would significantly weaken a Debtor's ability to function – i.e. if a supplier were not paid for goods and threatened to withhold future shipments, jeopardizing the Debtor's business and reorganization.

An example of a District Court allowing a Debtor to pay unsecured creditors pre-petition is In re Just for Feet, Inc., 242 B.R. 821 (D. Del. 1999), in which the United States District Court for the District of Delaware allowed Just for Feet, Inc., to continue to purchase name-brand athletic footwear from its vendors. Just for Feet, which filed for bankruptcy in 1999, was a shoe store that primarily sold name-brand athletic shoes. If the Court refused the Debtor's request to pay unsecured creditors' claims for pre-petition goods, the business would have ceased to exist because the Debtor would not have been able to buy merchandise for its stores.

For more information on the Doctrine of Necessity and the powers of Bankruptcy Courts, please contact Jim Shenwick of Shenwick & Associates

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