The United States Court of Appeals for the Third Circuit plays a uniquely important role in the development of the bankruptcy laws.  The liberal venue rule for bankruptcy cases set out in 28 U.S.C. § 1408 has led to the disproportionate filing of large and mega chapter 11 bankruptcy cases being filed in the District of Delaware.  The decisions of the Third Circuit are binding on the District Court and Bankruptcy Court for the District of Delaware.  Consequently, the decisions of the Third Circuit govern that disproportionate number of large and mega chapter 11 cases.  Furthermore, because the bankruptcy court decisions in these mega cases often involve greater dollar amounts, they are more likely to be appealed, which can result in the Third Circuit being one of the few circuit courts to address a given issue.

In Official Committee of Unsecured Creditors v. CIT Group/Business Credit Inc. (In re Jevic Holding Corp.), 787 F.3d 173 (3d Cir. 2015), the Third Circuit recently considered the propriety of a “structured dismissal” of a chapter 11 case that provided for a distribution of estate assets contrary to the distributional scheme set out in the Bankruptcy Code.  In Jevic, the debtor was woefully insolvent.  Its secured creditors were owed millions more than the value of the debtor’s assets.  The Official Committee of Unsecured Creditors, however, challenged the secured creditors’ claims on fraudulent conveyance and preference theories.  That litigation lasted for several years, and the Committee’s claim eventually survived a motion to dismiss the case.  At that point, the secured creditors, the debtor and the Unsecured Creditors’ Committee agreed to settle the litigation.  Under the terms of the settlement, nearly $4 million was made available to the Committee and a litigation trust, with those funds available for use in the pursuit of unrelated litigation in the bankruptcy case.  Any amount remaining after such litigation would be distributed to general unsecured creditors.  The claims against the secured creditors were dismissed with prejudice, and the chapter 11 case was to be dismissed.  Conspicuously absent from the parties who reached the settlement was a group of truck drivers who held an uncontested WARN Act claim against the debtor for its failure to provide the required statutory notice prior to closing the business.  A significant portion of that WARN Act claim was entitled to priority over the claims of general unsecured creditors under Bankruptcy Code § 507 (a)(4).  Nevertheless, the claim would not be paid under the settlement even though general unsecured creditors would receive at least a partial payment on their claims.

This “skipping” of the priority claims of the drivers would be in violation of the so-called absolute priority rule of chapter 11.  The absolute priority rule provides that among unsecured creditors, priority creditors must be paid in full before any distribution is made to the general unsecured creditors, and no distribution can be made to the holders of equity interests in the debtor until the general unsecured claims have been paid in full.  11 U.S.C. § 1129(b)(2).  These rules are subject to adjustment, however, if a class of creditors accepts a less favorable treatment under the terms of a confirmed plan of reorganization.  In the absence of such an agreement, however, the priority is generally considered to be “absolute.”

The drivers objected to the settlement, but the bankruptcy court found that the settlement could be approved under Bankruptcy Rule 9019.  The bankruptcy court concluded that since the approval was being entered under Bankruptcy Rule 9019, it did not have to comply with the absolute priority rule that applies in the context of plan confirmation.  It further found that the proposed settlement complied with the standards applicable in the Third Circuit to settlements under Rule 9019.  The bankruptcy court also found that the settlement would resolve a matter that would have been very costly to pursue and very likely to have been unsuccessful in any event.  As such, the bankruptcy court reasoned that if the settlement were not approved, the unsecured creditors would most likely not receive anything.  Given this finding, the court reasoned that the drivers whose claims were being ignored for the benefit of “lower” priority creditors really were not losing anything, because, absent the settlement, they likely would not receive anything.  Thus, the bankruptcy court found the settlement to be in the best interest of creditors because the drivers were no worse off than they would have been absent the settlement, and the other unsecured creditors were slightly better off, being entitled to receive a small distribution.

The district court affirmed the bankruptcy court’s decision approving the settlement.  It found that the settlement need not meet the absolute priority rule and further that the appeal was equitably moot because the drivers had not obtained a stay of the order approving the settlement.  The truck drivers then appealed to the Third Circuit which again upheld the lower court’s decision.

The majority of the Court of Appeals held that the Bankruptcy Code did not prohibit the structured dismissal even if it was inconsistent with the distributional scheme set out in the Code.  Rather, the court noted that:

though § 349 of the Code contemplates that dismissal will typically reinstate the pre-petition state of affairs by revesting property in the debtor and vacating orders and judgments of the bankruptcy court, it also explicitly authorizes the bankruptcy court to alter the effect of dismissal “for cause”—in other words, the Code does not strictly require dismissal of a Chapter 11 case to be a hard reset.

The court also noted that as in all litigation, settlements are favored.  This favored status, the court indicated, is especially appropriate in bankruptcy cases.  Nonetheless, the court, in affirming the lower court’s approval of the settlement, called it a “close call.”  The appellate court stated that the result would be appropriate “only rarely” and was proper in this case because of the bankruptcy court’s finding that there was no prospect for a realistic reorganization nor a chapter 7 case that would have done anything other than quickly distributing all of the assets to a secured creditor.

A vigorous dissent by Judge Scirica rejected the notion that the parties could not have reached a different settlement.  Additionally, he stated that:

the settlement deviates from the Code’s priority scheme so as to maximize the recovery that certain creditors receive, some of whom (the unsecured creditors) would not have been entitled to recover anything in advance of the WARN Plaintiffs had the estate property been liquidated and distributed in Chapter 7 proceedings or under a Chapter 11 “cramdown.” There is, of course, a substantial difference between the estate itself and specific estate constituents. The estate is a distinct legal entity, and, in general, its assets may not be distributed to creditors except in accordance with the strictures of the Bankruptcy Code.

Given this deviation from the Code’s distributional scheme, Judge Scirica would have allowed the settlement as made with the exception that he would have required the lower court to determine the extent of the priority claim held by the truck drivers and would have ordered the distribution of funds in the estate to the priority creditors with any amounts remaining thereafter to be distributed to the general unsecured creditor class.

WHAT DOES THIS MEAN FOR FUTURE CASES

Allowing structured settlements that violate the Bankruptcy Code’s distributional scheme, even in “rare” instances, will encourage collusion between and among participants in bankruptcy cases to ensure the payment of some claims to the exclusion of others.  The only limit on that “redistribution imperative” is the imagination of the parties or their animus to specific other parties.  The Third Circuit’s statement that these settlements in contravention of the statutory distributional scheme will rarely be appropriate may not hold true.  The factual predicate inJevic –that the parties would not agree to settle without making a payment to a lower priority creditor– can easily be replicated in future cases.  This simply advises parties in the future to adopt that stance aggressively.

There is a similar directive in §364 of the Bankruptcy Code which requires that the court find that postpetition credit is not available on an unsecured basis as a prerequisite to the approval of a secured loan.  Additional similar findings are required for the court to approve secured loans that prime existing secured claims.  Needless to say, the proof of these prerequisites has not proven insurmountable in many cases.  Furthermore, the standards set out in the statute essentially set the framework for postpetition lenders to assert their requirements for making their loans.  It stands to reason that readers of the Jevic will be similarly educated regarding how to establish the prerequisites for approval of structured settlements.  This will shift significantly the leverage parties hold in the negotiating process.  On the one hand, creditors who unreasonably withhold their consent to try squeeze perhaps excessive recoveries will face the prospect of being entirely shut out of any recovery on their claims.  Conversely, those pushing the settlement are encouraged to craft settlements that would minimize or ignore some claims knowing that a “deadlock” might be broken by the court.

Only the passage of time will tell us whether the Third Circuit’s decision approving a settlement that violates the absolute priority rule will lead to substantially more such structured settlements.  The court was unmoved by the argument asserted by the United States Trustee in the case that there are times when the Code simply does not allow a specific solution, even if it may result in an economic loss.  Rather, the court said that national bankruptcy policy is not “so nihilistic and distrustful of bankruptcy judges.”  This view may be difficult to square with many statements by the Supreme Court that the “plain meaning” of the Code is dispositive.  It is also arguably inconsistent with much legislative history of the Code, and particularly more recent amendments to the Bankruptcy Code, that call for the reining in of the discretion of bankruptcy judges.