Benjamin Franklin is quoted as having said “in this world nothing can be said to be certain, except death and taxes.”  No offense to Mr. Franklin, but we had always thought that there was at least one other certainty in this world—in a bankruptcy case, creditors get paid pursuant to the priority scheme under section 507(a) of the Bankruptcy Code.  It turns out, however, that Mr. Franklin was correct.  In In re Jevic Holding Corp., the United States Court of Appeals for the Third Circuit found that in rare instances, a case arising under chapter 11 may be resolved through a structured dismissal that deviates from the Bankruptcy Code’s priority scheme.  An overview of structured dismissals and a discussion of the Third Circuit’s analysis in this case as to whether such dismissals are generally permissible under the Bankruptcy Code is provided in Part I here.  In this Part II, we discuss whether bankruptcy courts have the power to approve settlements, in the context of structured dismissals, which deviate from the priority scheme of the Bankruptcy Code. 

Background

In May of 2008, Jevic Transportation, Inc. and certain of its affiliates commenced a chapter 11 proceeding in the United States Bankruptcy Court for the District of Delaware.  Upon filing, Jevic owed approximately $53 million to its first-priority secured creditors—certain entities affiliated with CIT Group and Sun Capital Partners—and more than $20 million to its tax and general unsecured creditors.

Two lawsuits were filed in the bankruptcy proceeding that are relevant to the Third Circuit’s decision in this case.  First, a group of terminated Jevic truck drivers commenced a class action alleging violations of federal and state Worker Adjustment and Retraining Notification (WARN) Acts.  Second, the unsecured creditors’ committee filed a fraudulent conveyance action against CIT and Sun Capital in connection with Sun Capital’s leveraged buy-out of Jevic prior to its bankruptcy filing.  The buy-out was financed by a group of lenders led by CIT.

A settlement agreement was ultimately reached among the creditors’ committee, CIT, and Sun Capital that called for, among other things, dismissal of the fraudulent conveyance action with prejudice, contribution by CIT of $2 million towards certain administrative expenses, assignment by Sun Capital of its lien on Jevic’s remaining assets to a trust, which would pay tax and administrative creditors first and then general unsecured creditors, and a structured dismissal of Jevic’s bankruptcy case.  The settlement did not include the drivers, even though they had an uncontested WARN Act claim against Jevic.  According to the drivers, a significant portion of their claim constituted a priority wage claim under section 507(a)(4) of the Bankruptcy Code—a higher priority than claims of the tax and trade creditors.  The settlement and dismissal were approved by the bankruptcy court over the objections of the drivers and the United States Trustee.  The drivers appealed to the United States District Court for the District of Delaware, which affirmed the bankruptcy court’s decision, and then to the Third Circuit.

Analysis

Majority Opinion

As a threshold matter, the Third Circuit found that a bankruptcy court has discretion to order a structured dismissal, absent a showing that such dismissal has been contrived to evade the protections and safeguards of the plan confirmation or conversion processes.  As noted above, we previously discussed the Third Circuit’s analysis of the permissibility of structured dismissals under the Bankruptcy Code.

The Third Circuit then considered the drivers’ argument that section 507 of the Bankruptcy Code applies to all distributions of estate property under chapter 11 and, as such, the bankruptcy court lacked the authority to approve a structured dismissal and settlement that skipped priority employee creditors in favor of tax and general unsecured creditors.  The Third Circuit recognized that in order for a bankruptcy court to authorize a settlement, it must be found to be “fair and equitable.”  Further it recognized that, in order to be confirmed, a chapter 11 plan also must be found to be “fair and equitable” and that this standard incorporates the absolute priority rule (i.e., generally senior creditors must be paid ahead of junior creditors).  The question before the Third Circuit was whether the fair and equitable standard incorporating the absolute priority rule applies to settlements in bankruptcy.  That is—whether a settlement could be found to be “fair and equitable” without complying with the absolute priority rule when the settlement is presented for approval to a bankruptcy court outside of the context of a chapter 11 plan.

The Fifth and Second Circuit Courts of Appeals both previously analyzed whether section 507’s priority scheme applies to the distribution of settlement proceeds in chapter 11 cases.  Fundamental to this analysis is the basic premise that, as noted above, a court may not confirm a plan unless it is “fair and equitable.”  The Court of Appeals for the Fifth Circuit in In the Matter of AWECO, Inc. ruled that the fair and equitable standard applies to settlements and “fair and equitable” means compliant with the priority scheme, even outside the context of a chapter 11 plan.  By contrast, the Second Circuit adopted a more flexible approach in In re Iridium Operating LLC and found that the absolute priority rule “is not necessarily implicated” when “a settlement is presented for court approval apart from a reorganization plan[.]”  The Second Circuit acknowledged that “whether a settlement’s distribution scheme complies with the [Bankruptcy] 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,’” a noncompliant settlement could beapproved when “the remaining factors weigh heavily in favor of approving the settlement[.]”

The Third Circuit agreed with the approach taken by the Second Circuit in Iridium.  The Third Circuit pointed out that settlements are favored in bankruptcy (as in other areas of the law) and reasoned that it makes sense that courts would have more flexibility in evaluating settlements than in confirming plans, given the “dynamic status of some pre-plan bankruptcy settlements.”  The Third Circuit was careful to note, however, that compliance with the Bankruptcy Code’s priority scheme will usually dictate whether a settlement satisfies the fair and equitable standard.  Settlement agreements that skip a dissenting class of creditors in distributing estate assets raise concerns regarding potential collusion.  Moreover, although the Third Circuit found that the absolute priority rule does not explicitly apply in the context of settlement agreements, the policy underlying that rule—ensuring the evenhanded and predictable treatment of creditors—does.  If the fair and equitable standard is to be meaningful, then bankruptcy courts cannot be permitted to approve settlements and structured dismissals aimed at increasing the share of estate assets distributed to certain creditors at the expense of others.  Therefore, the Third Circuit held that bankruptcy courts may approve settlements that deviate from the priority scheme of section 507 only if they have “specific and credible grounds to justify [the] deviation.”

Recognizing that it was a close call, the Third Circuit concluded that the Bankruptcy Court had sufficient reason to approve the settlement and structured dismissal of Jevic’s bankruptcy case as it was the “least bad alternative.”  There was no prospect of a plan being confirmed and conversion to chapter 7 would have simply resulted in all of the estate assets going to the secured creditors.  Although noting that it was regrettable that the drivers were left out of the settlement, the court ruled that there was no support in the record for the proposition that a viable alternative existed that would have better served the estate and the creditors as a whole and recognized that the bankruptcy court, in “‘Solomonic fashion,’ reluctantly approved the only course that resulted in some payment to creditors other than CIT and Sun.”

Dissent

Judge Scirica agreed with the majority that the Second Circuit’s standard in Iridium was the correct one to apply, but concluded that this was not a case of extraordinary circumstances that justified deviating from the Bankruptcy Code’s priority scheme.  First, Judge Scirica reasoned that it was not necessarily the case that the only alternative to the settlement agreement was a conversion to chapter 7.  Rather, the parties could have reached a settlement agreement that included the drivers and complied with the Bankruptcy Code’s priority scheme.  The reason that such a settlement was not reached was that Sun Capital—one of the defendants in the WARN Act litigation—did not want to provide funds that would ultimately be used to finance a litigation in which it was a defendant.  Judge Scirica also concluded that the settlement was at odds with the goals of the Bankruptcy Code and noted that it was not directed at estate-value maximization, but rather at the recovery maximization for certain creditors.  Accordingly, Judge Scirica concluded that he would not unwind the settlement entirely, but would alter it such that any proceeds distributed to creditors with a lower priority than the drivers would be disgorged and applied to satisfy the drivers’ wage priority claims.

Conclusion

The Third Circuit’s ruling in this case is a significant one.  It provides a mechanism—the structured dismissal—for a debtor to restructure without having to comply with the Bankruptcy Code’s priority scheme.  It remains to be seen, however, how broadly this decision will be interpreted by other courts.  Significantly, the Third Circuit was careful to specify that its decision in this case was a “close call.”  The Third Circuit also warned that compliance with the Bankruptcy Code’s priority scheme will usually dictate whether the fair and equitable standard has been satisfied.  These aspects of the decision, among others, could provide future courts with ample leeway to interpret this case narrowly.