RULING PUTS DISPOSITION OF KMART PAYMENTS IN QUESTION

VICKI M. YOUNG

NEW YORK -- Kmart may be out of bankruptcy, but it is still mired in intrigue.

The Seventh Circuit Court of Appeals in Chicago has determined that the old bankrupt Kmart company, based in Troy, Mich., should not have paid $367 million to certain former key suppliers, which could include bankrupt grocery wholesaler Fleming Cos., Dallas.

The decision could be an administrative headache for the holding company that owned Kmart before it emerged from bankruptcy last May, but it also raised issues concerning its impact on Kmart Holding Corp., the entity that owns the surviving operating assets.

Under the terms of the reorganization plan, unsecured creditors are to receive satisfaction of their claims via equity in the new Kmart. However, new funds heading back into Kmart's estate is a scenario that raises a lot of questions, which include: Does ESL Investments, the hedge fund that is Kmart's largest shareholder, find its stake diluted? Do trade creditors now own a bigger part of Kmart? According to a Kmart source, there's already been a partial distribution to creditors under the plan.

Officials at ESL could not be reached for comment. A spokesman for Kmart said, "Kmart does not intend to appeal the circuit court's decision."

Adding to the intrigue is where the returned payments actually go -- to the estate for redistribution to creditors of the former Kmart or to the current Kmart Holding Corp.? Of course, the old Kmart doesn't exist anymore, but its estate could presumably be opened up to handle the new administrative loose ends.

A survey of bankruptcy professionals indicated that the money belongs to creditors, who potentially could end up with a larger slice of Kmart's equity pie. A source inside Kmart disputes that, saying the company believes the return of vendor payments goes directly to the new Kmart.

First, Kmart will have to figure out how to collect.

The circuit court decision was not immediately available. The court's jurisdiction includes Indiana, Illinois and Wisconsin. The decision was in regard to critical vendors who provide goods and services considered so important that their pre-Chapter 11 bills get paid immediately, ahead of other creditors. Others must wait until after the conclusion of the bankruptcy for their claims to be heard. As unsecured creditors, they also tend to get pennies on the dollar.

In the Kmart bankruptcy proceedings, Chicago Bankruptcy Judge Susan Pierson Sonderby authorized payments to certain Kmart unsecured creditors, but Capital Factors, which failed to garner critical vendor status, appealed that decision to the federal district court in Chicago. In April, U.S. District Court Judge John Grady reversed Judge Sonderby's decision.

In the opinion dated April 8, 2003, Judge Grady concluded that the Chicago bankruptcy court had neither the "statutory [nor] equitable power to authorize" the preplan payment of pre-petition unsecured claims, and sent the matter back to the bankruptcy judge for further adjudication. Kmart appealed. The circuit court in Chicago last week affirmed Judge Grady's ruling, stating Kmart's request to make the payments should not have been approved because the retailer didn't justify it.

Adam Rogoff, bankruptcy law partner at Cadwalader, Wickersham & Taft, said, "There's no question that the vendors have to return those payments. The circuit court made that very clear."

Kmart declined to say whether it may need to start a flurry of lawsuits to recover the now-unauthorized payments. That could be difficult in the case of Fleming, the wholesaler that filed for Chapter 11 bankruptcy court protection itself last April.

Meanwhile, Kmart is set to report fourth-quarter earnings and year-end results on March 18.

The retailer already has laid off some full-time employees. The idea is to convert some full-timers into part-timers, and have them staff the stores when there is the most foot traffic.

Kmart also has identified for closure eight stores since it emerged from bankruptcy. Some of those locations are still in operation. Two sites were shuttered because of redevelopment by the developer; four in Northern California had leasehold interests that were sold; and one each in Michigan and Oklahoma were set to close because Kmart elected not to renew the underlying leases.