A federal judge has overturned a US bankruptcy court's decision allowing Kmart Corporation to make some US$300 million in payments to key creditors it owed before it filed for protection from its creditors.

Letter of credit (L/C) holders were amongst the creditors who just a few weeks ago thought they had moved to the head of the queue for payments from the beleaguered US retailer.

Business continuity

"They simply are not authorised by the bankruptcy code," US District Judge John F Grady said of the payments in his recently issued written opinion.

The Michigan based retailing giant sought permission to make the payments shortly after it filed for bankruptcy in January 2002, saying the creditors had to be paid or they would stop shipping merchandise needed to keep stores operating.

Protection

Filing for bankruptcy under Chapter 11 in the US provides a company with protection from its creditors while it plans a recovery package. The bankruptcy court must approve this plan before creditors are paid.

But Kmart wanted to pay selected creditors in full, almost immediately after it went into bankruptcy and long before it drew up plans for recovery.

L/C payments approved

US Bankruptcy Court Judge Susan Sonderby, presiding in the Kmart case, approved requests by Kmart for permission to pay selected suppliers. She subsequently approved payments to holders of L/Cs from Kmart as well as the company's liquor suppliers.

A company that holds unsecured claims against Kmart totalling US$20 million, Capital Factors Inc, appealed Sonderby's rulings on the payments.

Payback time

Courts in the US disagree over whether payments similar to those initially approved by Kmart are permissible, a point Grady notes in his written opinion. He however found that "the Bankruptcy Court did not have either the statutory or equitable power to authorise the pre-plan payment of pre-petition unsecured claims."

He said the payments would have to be returned.

Appeal

Kmart's counsel argued in the appeal court that Sonderby's decisions should not be overturned because the corporation would have to file several lawsuits to force creditors return payments. Grady said Sonderby could simply order them to return the money.

Kmart issued a statement saying it has appealed the appeal court ruling.

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