On May 21, 2015, the United States Court of Appeals for the Third Circuit (the “Third Circuit”) affirmed the order of the United States District Court for the District of Delaware in Official Committee of Unsecured Creditors v. CIT Group/Business Credit Inc. (In re Jevic Holding Corp.) approving a settlement and dismissal of a chapter 11 case by way of a “structured dismissal.” A structured dismissal is, simply, the dismissal of the bankruptcy case preceded by other orders, such as an order approving a settlement or granting releases, which survive dismissal of the case. In a case of first impression, the Third Circuit held that bankruptcy courts are permitted to use structured dismissals, and in rare instances, may be justified in approving structured dismissals that do not strictly adhere to the Bankruptcy Code’s priority scheme. Specifically, the Third Circuit held that structured dismissals are permitted if a bankruptcy judge determines that (i) the traditional routes out of chapter 11 are unavailable and (ii) the settlement is the best feasible way of serving the interests of the estate and its creditors.

Background

In 2006, Jevic Transportation, Inc. (the “Company”), a trucking company based in New Jersey, was acquired through a leveraged buyout by a subsidiary of Sun Capital Partners (“Sun Cap”), a private equity firm. Sun Cap financed the buyout with a group of lenders led by CIT Group. The Company struggled significantly in the two years following the buyout, ceased substantially all operations, and terminated its employees on May 19, 2008. The following day, the Company filed a voluntary petition for relief under chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”). On the petition date, the Company owed $53 million to its first-priority senior secured creditors, Sun Cap and CIT, and over $20 million to its tax and general unsecured creditors. In June 2008, an official committee of unsecured creditors (the “Committee”) was appointed to represent the unsecured creditors.

The issues on appeal to the Third Circuit arose out of two lawsuits that were filed in the bankruptcy case. The first, a class action filed by a group of former Jevic truck drivers (the “Drivers”) against the Company and Sun Cap, alleged that the Company violated federal and New Jersey labor laws1 when it failed to provide 60-days’ notice to its employees prior to their termination. While the Bankruptcy Court granted summary judgment in favor of Sun Cap, as it found that Sun Cap did not qualify as an employer of the Drivers, it did conclude that the Company “undisputedly” violated the WARN Act. The second action, which included fraudulent conveyance and preference claims, was filed by the Committee on behalf of the estate against CIT and Sun Cap.

In March 2012, the Committee, CIT, Sun Cap, the Drivers and the Company negotiated and entered into a settlement agreement, which would result in the dismissal of the case. The settlement agreement included the following conditions: (i) the parties would provide mutual releases and dismissal of the fraudulent conveyance action; (ii) CIT would pay $2 million with respect to the charges for professional services rendered for the Company and the Committee; (iii) Sun Cap would assign its lien on the Company’s remaining assets to a trust, which would pay tax and administrative creditors first and then general unsecured creditors on a pro rata basis, and (iv) the chapter 11 case would be dismissed. These settlement conditions would survive dismissal of the bankruptcy case, rather than return the parties to their pre-bankruptcy positions, as is customary after the dismissal of a bankruptcy case. Such settlements are often referred to as “structured dismissals.”

Missing from the settlement, however, was the Drivers’ uncontested WARN Act claim. The Drivers estimated their claim to be valued at approximately $12.4 million, with $8.3 million consisting of a priority wage claim under section 507 of the Bankruptcy Code.2 Though the record was unclear as to why the Drivers were excluded from the settlement, the Third Circuit speculated that the parties were unable to reach a satisfactory resolution of the claim, possibly because the Drivers’ priority claim would have left the other creditors with nothing.

The Drivers and the United States Trustee objected to the proposed settlement and dismissal, arguing that the settlement violated statutory priority requirements under section 507 by paying creditors with claims junior to the Drivers’ priority wage claim without paying the Drivers in full for their priority claim. The Drivers also argued that the Committee breached its fiduciary duties to the estate by agreeing to a settlement that froze out the Drivers. In addition, the United States Trustee asserted that the Bankruptcy Code does not permit structured dismissals.

In an opinion from the bench, the Bankruptcy Court overruled the objections and approved the proposed settlement and dismissal. It held that the “dire circumstances” in the case warranted the settlement’s approval. Specifically, the Bankruptcy Court noted that the estate was severely depleted, as the only assets were $1.7 million in encumbered cash and the value of the claims in the litigations. The Bankruptcy Court concluded that because there was “no prospect” of a confirmable chapter 11 plan and the estate did not have enough money to cover the costs of a chapter 7 liquidation, the settlement was the only way of achieving any meaningful distribution to creditors other than the secured creditors. The Bankruptcy Court also found that the structured dismissal did not violate the absolute priority rule because settlements are not subject to the priority requirements that govern chapter 11 plans.

The Drivers appealed the Bankruptcy Court decision to the United States District Court for the District of Delaware (the “District Court”), which affirmed the Bankruptcy Court order in its entirety. The Drivers subsequently appealed the District Court ruling to the Third Circuit 

Third Circuit Decision

In their appeal to the Third Circuit, the Drivers and the United States Trustee argued that (i) the Bankruptcy Court lacked legal authority to approve a structured dismissal, and (ii) even if the Bankruptcy Court was permitted to authorize a structured dismissal, the Bankruptcy Court could not approve a structured dismissal that deviated from the Bankruptcy Code’s priority requirements for distributing estate assets.

a. Discretion to Allow Structured Dismissal

Addressing the first point, the Third Circuit considered whether structured dismissals are ever permissible under the Bankruptcy Code. It agreed with the Drivers that there was no explicit statutory authority for structured dismissals, observing that under section 349 of the Bankruptcy Code, dismissals typically reinstate the prepetition state of affairs by revesting property in the debtor and vacating orders of the bankruptcy court. However, the court also noted that section 349(b) provides bankruptcy courts with statutory authority to alter the effects of dismissal “for cause.” The Third Circuit chose not to address whether structured dismissals were permissible when other worthwhile alternatives exist, as there were no viable alternatives at the time the Bankruptcy Court dismissed the case. Ultimately, the Third Circuit determined that the Bankruptcy Court had discretion to order a structured dismissal, but qualified that a structured dismissal must not have been contrived to evade the procedural protections and safeguards of the plan confirmation or case conversion processes.

b. Deviating from the Absolute Priority Rule

Having established that the Bankruptcy Court was permitted to order a structured dismissal, the Third Circuit then examined whether the settlement in the context of the structured dismissal was permitted to deviate from the Bankruptcy Code’s priority scheme. The Third Circuit acknowledged that the Drivers’ objection was “not without force,” explaining that the law generally requires bankruptcy courts to exercise equitable powers within the confines of the Bankruptcy Code. Further, the Third Circuit noted that the Supreme Court held3 that the Bankruptcy Code’s “fair and equitable” standard, which incorporates the “absolute priority doctrine” and requires that a plan of reorganization pay senior creditors before junior creditors in order to be confirmable, applies to compromises just as to other aspects of reorganizations. To the contrary, the Third Circuit noted that, neither Congress nor the Supreme Court have expressly stated that the absolute priority rule applied to settlements in bankruptcy, and thus, the Third Circuit held that in this context, it did not apply. In that regard, the Third Circuit considered whether the underlying legal principles of fairness and equity embodied by the absolute priority rule did apply. The Third Circuit noted a split among the two circuit courts that had considered the issue in the context of settlements.

In In re AWECO, Inc., 4 the Court of Appeals for the Fifth Circuit rejected a settlement proposal that sought to transfer estate assets to an unsecured creditor ahead of outstanding senior claims. It held that settlements that do not adhere to the Bankruptcy Code’s priority scheme are prohibited per se. 

The Court of Appeals for the Second Circuit disagreed with the Fifth Circuit’s position. It adopted a more flexible approach in In re Iridium Operating LLC5 , holding that the absolute priority rule was “not necessarily implicated” when a settlement is presented to a court for approval under Rule 9019 of the Federal Rules of Bankruptcy Procedure outside of a plan of reorganization. In Iridium, the proposed settlement would have split the estate’s assets between its secured lenders and a litigation trust, which was set up to fund a litigation brought by the unsecured creditors’ committee against a priority administrative creditor. The administrative creditor objected to the settlement on the grounds that it violated the Bankruptcy Code’s priority system. The Second Circuit held that this deviation was acceptable. It reasoned that the most important factor for courts to consider when evaluating whether a settlement is “fair and equitable” is whether a particular settlement complies with the Bankruptcy Code’s priority scheme. The absence of this factor, however, is not always fatal, and may be overcome if the remaining factors weigh heavily in favor of approving a settlement. The facts in Iridium justified the settlement’s deviation from the priority scheme, because the alternative to settling, which was to engage in extensive litigation challenging certain liens, presented too much risk of depleting the estate.

The Third Circuit agreed with the Second Circuit’s holding in Iridium, noting that bankruptcy courts should have more flexibility in approving settlements than in confirming plans of reorganization. It also agreed that compliance with the Bankruptcy Code’s priority rules would usually be dispositive of whether a proposed settlement is fair and equitable. The Third Circuit concluded, however, that while the absolute priority rule did not apply to settlements, the underlying policy of the rule did. Therefore, the Third Circuit held that bankruptcy courts were permitted to approve settlements that deviated from the Bankruptcy Code’s priority scheme only if they have “specific and credible grounds to justify the deviation.” The Third Circuit noted that this result is likely to be justified only rarely.

The Third Circuit found that although the decision in the present case was a “close call,” the Bankruptcy Court had sufficient reason to approve the settlement and structured dismissal of Jevic’s chapter 11 case. There were no viable alternatives – no prospect of a plan being confirmed, and a chapter 7 liquidation would have provided unsecured creditors with nothing – and the settlement was the “best feasible” way of serving the interest of both the estate and creditors.

Conclusion

The Third Circuit’s decision is significant because it is the first by a Circuit Court to allow the use of a structured dismissal that deviates from the statutory priority scheme of the Bankruptcy Code. While structured dismissals are not common, the rationale used to approve it in this case does implicate the use of settlement agreements in general that do not strictly adhere to the absolute priority rule.