A settlement providing for dismissal of a Chapter 11 case and distribution of estate property “that deviates from the Bankruptcy Code’s priority” scheme is permissible, held a divided panel of the U.S. Court of Appeals for the Third Circuit on May 21, 2015. Official Committee of Unsecured Creditors v. CIT Group/Business Credit Inc. (In re Jevic Holding Corp.), 2015 WL 2403443, at *1 (3d Cir. May 21, 2015) (2- 1) (“Jevic”). In Jevic, an excluded group of terminated employees (the “Employees”) holding priority wage claims appealed from a court-approved settlement that had denied them a distribution but had provided lower-priority general unsecured creditors with a distribution from estate assets. Id. at *2 n.1. According to the Employees and the U.S. Trustee, the Bankruptcy Code’s (the “Code’s”) priority scheme should have been applied in the settlement context here. Id. at *3, *6.
Reasoning that bankruptcy courts have more flexibility in approving settlements than in confirming reorganization plans, the Third Circuit refused to adopt a purportedly “too rigid” rule advocated by the Employees. Id. at *8. Rather, it held that “bankruptcy courts may approve settlements that deviate from the priority scheme of … the Bankruptcy Code only if they have ‘specific and credible grounds to justify the deviation.’” Id. at *9 (citation omitted). Finding that the settlement in Jevic “remained the least bad alternative” for the estate and its creditors, the Third Circuit affirmed the bankruptcy court’s approval of the settlement, as had the district court.
Relevance of the Case
Jevic stretches the limits of a bankruptcy court’s authority to approve Chapter 11 case dismissal orders. The Code presents three exit options available in a Chapter 11 case: (1) reorganization or liquidation under a confirmed Chapter 11 plan; (2) conversion to a Chapter 7 liquidation; or (3) dismissal. Dismissal ordinarily restores the status quo that existed prior to the bankruptcy petition date. Id. at *5. Liens are reinstated; property reverts to its pre-bankruptcy owner; and most bankruptcy court orders are vacated. See Code § 349.
Imaginative parties have recently introduced a fourth option. A “structured dismissal” offers an exit path that provides for both dismissal of the case and preservation of certain pre-dismissal bankruptcy court orders. Structured dismissal orders often contain provisions typically found in reorganization plan confirmation orders such as those governing distributions and releases.
Despite the structured dismissal’s emergence as an exit strategy, the Code makes no provision for it. Courts and petitioners have debated its propriety. Proponents view such a dismissal as a quick and cost- efficient way to wind down an estate after liquidating a debtor’s assets. Critics, however, argue that structured dismissals may “alter parties’ rights without their consent [while evading] many of the [Code’s] most important safeguards.”1 The real issue in Jevic was “whether settlements in [the] context [of a structured dismissal] may even skip a class of objecting creditors in favor of more junior creditors.” 2015 WL 2403443, at *6. Indeed, as the court conceded, “[s]ettlements that skip objecting creditors in distributing estate assets raise justifiable concerns about collusion among debtors, creditors, and their attorneys and other professionals.” Id. at *9. Sensitive to these concerns, the majority of the court in Jevic still approved the use of a structured dismissal “in rare instances like this one.” Id. at *5.
Prior to its bankruptcy filing, a subsidiary of a private equity firm (“Sub”) acquired Jevic in a leveraged buyout financed by a group of lenders (“Lender”). Jevic struggled financially and later required a forbearance agreement with Lender to prevent an immediate foreclosure. Shortly before the expiration of the forbearance agreement in May 2008, Jevic’s board authorized a Chapter 11 filing. The company then ceased operating and notified the Employees of their impending termination.
At the time of its bankruptcy filing, Jevic owed about $53 million to secured creditors plus $20 million to tax and general unsecured creditors. In the bankruptcy case, Jevic’s creditors’ committee (the “Committee”) filed a fraudulent transfer action against Lender and Sub alleging that the ill-advised buyout “hastened Jevic’s bankruptcy.” In addition, the Employees sued Jevic and Sub for alleged WARN Act violations relating to the pre-bankruptcy layoffs.
Sub, Lender, the Committee and the Employees eventually commenced settlement negotiations. By then, however, “Jevic’s only remaining assets were $1.7 million in cash (which was subject to [Sub’s] lien) and the action against [Lender and Sub].” Ultimately, the Committee, Lender and Sub — but not the Employees — agreed to the dismissal of Jevic’s Chapter 11 case and a distribution of the estate’s remaining cash, first to tax and administrative claimants and then to unsecured creditors. According to the bankruptcy court, without a settlement, there was “no realistic prospect of a meaningful distribution to Jevic’s unsecured creditors.” Critically, the settlement offered no distribution to the Employees who held a substantial priority wage claim under Code Section 507(a)(4).
The Employees and U.S. Trustee objected to the proposed settlement “because it distributed property of the estate to creditors of lower priority than the [Employees] under … the Bankruptcy Code.” Id. at *3. The U.S. Trustee also argued that the Code does not permit structured dismissals like the one proposed here. According to the Employees, structured dismissals evade the established procedures governing Chapter 11 exit options — namely, plan confirmation or conversion to Chapter 7. Although Code Section 349 allows courts to modify the effect of dismissal “for cause,” Congress would, they argued, have spoken directly had it intended to relax the procedural safeguards in such a drastic manner.
The Bankruptcy and District Courts
The bankruptcy court acknowledged the absence of Code authority supporting this settlement but still approved it because “the dire circumstances … warrant[ed] the relief requested by the Debtor.” According to the bankruptcy court, “there was no ‘realistic prospect’ of a meaningful distribution to anyone but the secured creditors unless the settlement were approved.” Both the bankruptcy court and district court agreed that, unlike reorganization plans, bankruptcy settlements do not necessarily need to “comply with the Code’s priority scheme” in order to be “fair and equitable.” Id. at *3, *4. The district court also held the Employees’ appeal equitably moot because the settlement funds had already been distributed.
The Court of Appeals
The Third Circuit rejected any broad prohibition of structured dismissals. Rather, it gave bankruptcy courts discretion to permit such relief when there has been no “showing that a structured dismissal has been contrived to evade the procedural protections and safeguards of the plan confirmation or conversion process.” Id. at *6.
The Third Circuit then turned to the validity of the class-skipping distribution in the Jevic settlement agreement. According to the Employees, the bankruptcy court had no authority to approve a distribution of “estate assets in derogation of the priority scheme of [Code] § 507.” Id. The Employees cited the U.S. Supreme Court’s decision in In re TMT Trailer Ferry, 390 U.S. 414, 424 (1968) (held, “fair and equitable” standard that incorporates absolute priority rule, applicable in plan confirmation context, also “app[lies] to compromises just as to other aspects of reorganizations”). In the view of the Third Circuit, however, TMT Trailer was decided in the plan confirmation context and should not be applied in the settlement context, particularly when “neither Congress nor the Supreme Court has ever said that the [absolute priority] rule applies to settlements in bankruptcy.” Id. at *7.
Both the Second and Fifth Circuits have addressed whether a settlement must comply with the Code’s priority scheme. The Fifth Circuit rejected a settlement that deviated from the Code’s priority scheme. In re AWECO, Inc., 725 F.2d 293 (5th Cir. 1984). There, the debtor sought to resolve litigation with a junior creditor through the transfer of approximately $5.3 million of estate assets over the objection of a senior secured creditor. Id. at 295-96. The Fifth Circuit found that the settlement may be fair as between a debtor and settling creditor but could still upset bankruptcy notions of fairness if it deprived senior creditors of full payment. Accordingly, it “held that the ‘fair and equitable’ standard [applicable] to settlements … means compliant with the priority system.”2015 WL 2403443, at *7 (quoting AWECO).
The Second Circuit, however, had rejected AWECO as “too rigid.” In re Iridium Operating LLC, 478 F.3d 452 (2d Cir. 2007). In Iridium, the settlement at issue sought to skip a distribution to a creditor asserting an administrative claim in favor of funding a suit against that very creditor. The Second Circuit found it difficult to employ a rule of priorities given the creditor’s disputed status as an administrative creditor. Id. at 464. The alternatives to the settlement, in its view, also “presented too much risk for the Estate.” Id. at 465. Accordingly, it held that compliance “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,” but that a bankruptcy court could still approve a noncompliant settlement if “the remaining factors weigh heavily in favor of approving a settlement.” Id. at 464.
Asserting the need to give bankruptcy courts flexibility to approve settlements, the Third Circuit rejected the per se rule of AWECO in favor of the Second Circuit’s Iridium standard. Yet the court was sensitive to the potential for some creditors to structure settlements that “increase their shares of the estate at the expense of other creditors.” 2015 WL 2403443, at *9. It thus held that “bankruptcy courts may approve settlements that deviate from the priority scheme of § 507 of the Bankruptcy Code only if they have specific and credible grounds to justify the deviation.” Applying this standard, the court found “that the Bankruptcy Court had sufficient reason to approve the settlement and structured dismissal of Jevic’s Chapter 11 case.” In the court’s view, the settlement “remained the least bad alternative since there was ‘no prospect’ of a plan being confirmed and conversion to Chapter 7 would have resulted in the secured creditors taking all that remained of the estate in ‘short order.’” Id.
Jevic purports to set limits on structured dismissals, at least as they relate to creditor distributions. Although Jevic’s holding is limited to those “rare instances” where neither a plan nor conversion represents a viable alternative, any liquidating Chapter 11 debtor may be faced with similar choices, as the dissent noted. The American Bankruptcy Institute Commission to Study the Reform of Chapter 11 (the “Commission”) addressed structured dismissals in its recently published Final Report and Recommendations but found that they would be unnecessary in light of the Commission’s other recommendations concerning asset sales.2
Jevic is significant because it authorizes bankruptcy courts to approve settlements that deviate from the Code’s priority scheme. It ostensibly gives parties added flexibility to resolve their disputes consensually while purporting to protect parties whose rights are vitiated by the settlement. The Employees in Jevic, left with nothing while junior creditors get a distribution, will not be convinced, however. For the sake of expediency, the Employees received no protection whatsoever.
The powerful dissent in Jevic apparently persuaded the Employees to seek en banc hearing by the entire Third Circuit. The dissent rejected the majority’s “undermin[ing] the Code’s essential priority scheme.” Id. at *11. First, in the dissent’s view, “departure from the general rule [of priorities]” was not “warranted.” “An alternative settlement might have been reached in Chapter 11” that could “have included” the Employees. Moreover, the settlement did not “maximize the estate’s overall value,” but merely “maximize[d] the recovery that certain creditors received, some of whom (the unsecured creditors) would not have been entitled to recover anything in advance of the [Employees]” in a Chapter 7 liquidation or Chapter 11 plan. Id. at *12.