The Bottom Line

In one of the first of many cases to determine the scope of the Supreme Court’s recent decision in Jevic, the Bankruptcy Court for the Eastern District of Tennessee denied a proposed settlement by the Debtor that the court found would circumvent certain of the Bankruptcy Code’s protections and priority scheme. Interestingly, the court relied on the Supreme Court’s dicta, rather than the holding, in Jevic in making its ruling. The case did not involve a structured dismissal, but rather a settlement during a chapter 11 case (although the effect of implementing the settlement would have resulted in a distribution to a secured creditor and likely led to a dismissal or conversion).

What Happened

The case, In re Willian Harry Fryar, 2017 WL 1489822 (Bankr. E.D. Tenn. Apr. 25, 2017), involves an individual chapter 11 Debtor who attempted to settle certain claims of his secured lender, Pinnacle Bank. Pinnacle held a mortgage of approximately $531,000 on two of the Debtor’s properties, which were also subject to liens asserted by the local taxing authorities and the IRS. The Debtor claimed that these properties were worth $200,000. The Debtor sought to sell his 50% interest in two businesses, on which the IRS also asserted liens, to the other equity owner for a total of $350,000 to retain his properties and avoid a foreclosure by Pinnacle.

Under the terms of the proposed settlement, the Debtor’s co-owner of the businesses would pay $350,000—financed by Pinnacle Bank—into the Debtor’s estate in return for 100% ownership of the two companies. The estate would then pay all of these sale proceeds to Pinnacle in exchange for a release of its mortgage on the Debtor’s properties. Pinnacle would also retain an unsecured deficiency claim of $181,000. The settlement did not propose to pay any of the tax liens asserted against the properties or the Debtor’s equity, even though Pinnacle acknowledged that under normal priority rules, the IRS liens would be paid ahead of its unsecured claim.

Three unsecured creditors and the United States Trustee objected to the settlement, arguing that the settlement proposed to pay Pinnacle’s claim ahead of more senior tax liens and would also pay part of Pinnacle’s unsecured deficiency claim ahead of similarly situated unsecured creditors. The Bankruptcy Court analyzed the proposed settlement under the standards of Bankruptcy Rule 9019. Citing to the Second Circuit’s decision in Iridium, 478 F.3d 452 (2d Cir. 2007), the Bankruptcy Court noted that “whether a particular settlement’s distribution scheme complies with the Code’s priority scheme must be the most important factor for the bankruptcy court to consider when determining whether a settlement is ‘fair and equitable’ under Rule 9019.”

After analyzing the operative settlement standards under Bankruptcy Rule 9019, using the recent dicta introduced in Czyzewski v. Jevic Holding Corp., No. 15-649, 2017 WL 1066259 (S. Ct. Mar. 22, 2017), the court found that in instances where pre-plan distributions under a settlement violate ordinary priority rules, the parties must show “significant Code-related objectives” associated with making such payments. In this case, the court found that the Debtor could not offer facts as to (i) why all of the cash coming into the estate should be paid to Pinnacle or (ii) how the settlement helps the Debtor move forward with a plan. The settlement was not part of a “first day” order to ensure ongoing business operations, nor did the settlement promote additional payments to creditors under a future plan. The Debtor’s prior chapter 11 case had been dismissed for failure to propose a plan, and the Debtor admitted that there was very little income in this case, with the only proceeds coming from the liquidation of assets. “The court’s review of the facts in this case leads it to conclude that this settlement is more of a preamble to a conversion or structured dismissal than it is to the situation in Iridium, where there was a reorganization anticipated.”

The Bankruptcy Court offered guidance to future debtors and creditors seeking approval of an interim settlement in chapter 11 cases, stating:

Parties who seek approval of settlements that provide for a distribution in a manner contrary to the Code’s priority scheme should be prepared to prove that the settlement is not only “fair and equitable” based on the factors . . . but also that any deviation from the priority scheme for a portion of the asserts is justified because it serves a significant Code-related objective. The proposed settlement should state that objective, such as enabling a successful reorganization or permitting a business debtor to reorganize and restructure its debt in order to revive the business and maximize the value of the estate. The proposed settlement should state how it furthers that objective and should demonstrate that it makes even the disfavored creditors better off.

Because the settlement involved a sale of assets of the estate and an agreement on the distribution of proceeds to only one creditor (Pinnacle), the court concluded: “To approve a settlement which is a sub rosa plan or a precursor for a conversion or dismissal in which the Code’s priority scheme is ignored would be an abuse of the bankruptcy court’s discretion.” Thus, the Court denied the settlement.

Why This Case is Interesting

Each case immediately interpreting Jevic is going to be reviewed carefully as bankruptcy courts examine how their brethren are assessing the scope of the Supreme Court’s ruling and its applications. In this case, dismissal or conversion was not part of the settlement but was viewed as a likely “next step” since confirmation of a plan was not practicable. On the one hand, the settlement enabled both a sale of assets and provided for a distribution of proceeds outside of a plan – always a caution area because of sub rosa plan concerns. However, the court expressly relied upon the Jevic decision’s dicta on when and how “interim” distributions should be allowed to “violate” priorities. The decision may also lead to other courts applying the “serves a significant Code-related objective” standard not only to settlements under Bankruptcy Rule 9019 but also to other more routine “interim” case relief (such as “first day” orders).