Introduction

The Supreme Court will consider these key questions next term in Czyzewski v Jevic Holding Corp:(1)

  • May a Chapter 11 debtor in dire straits settle claims of the bankruptcy estate, receive court approval to distribute the settlement proceeds to junior creditors without paying priority claims and then obtain dismissal of the bankruptcy case on terms that leave the priority-skipping settlement intact?
  • Alternatively, does such a resolution violate essential aspects of the Bankruptcy Code?

Facts

Jevic Holding Corp filed for bankruptcy in 2008 in the wake of a leveraged buy-out and the worldwide financial downturn. Its acknowledged debts included $53 million owed to two secured parties – the buy-out firm (Sun Capital) and a lender that had refinanced the leveraged buy-out debt (CIT) – plus about $20 million in obligations to general unsecured creditors. In addition, the bankruptcy ignited two litigations involving substantial claims:

  • Certain employees of the debtor whose jobs had been terminated the day before the bankruptcy filing filed a class action against Jevic and Sun Capital. The class complaint alleged violations of federal and state Worker Adjustment and Retraining Notification statutes that entitle workers to advanced notice of termination. Damages to the class were estimated at $12.4 million, of which $8.3 million constituted wage claims entitled to priority under Section 507(a)(4) of the Bankruptcy Code.(2)
  • A statutory unsecured creditors' committee, holding the powers of a bankruptcy trustee, brought fraudulent conveyance and preference claims against the secured parties for the benefit of the bankruptcy estate (the 'clawback claims'). If the clawback claims proved meritorious, the bankruptcy estate stood to recover more than $100 million.

Almost four years into the bankruptcy, the parties undertook negotiations for settlement of the clawback claims. By then, the bankruptcy court had upheld the facial sufficiency of certain of the clawback claims under Sections 547 and 548 of the Bankruptcy Code, thereby posturing the lawsuit as a contest on the facts. The class claimants refused to give up the wage claims in settlement of the clawback claims. On the other hand, Sun Capital was unwilling to fund any settlement in which money would go to persons who were pursuing their firm as a defendant on the wage claims.

By this time the estate was administratively insolvent – that is, the expenses of administration and other priority claims exceeded the estate assets unencumbered by the secured parties' liens. As all tangible assets had been sold off to pay down secured debt and all remaining cash on hand was subject to lien, the clawback claims were the only unencumbered assets left in the estate. Yet, there was no money in the estate to fund the further prosecution of these claims, and no attorney had offered to take up the cause on a contingent-fee basis.

The upshot was a proposed settlement among Jevic, the secured parties and the unsecured creditors' committee, while the holders of wage claims stood apart. The proposal called for:

  • CIT to pay $2 million towards administrative expenses, including the fees of the committee's counsel; and
  • Sun Capital to assign its lien on remaining cash ($1.7 million) to a trust for payment of other administrative claims and certain tax claims.

The proposed settlement would include dismissal with prejudice of the clawback claims and dismissal of the bankruptcy case itself. The settling parties would exchange releases purporting to extinguish not only the clawback claims of the estate, but also any fraudulent conveyance claims or other causes of action creditors could otherwise have pursued for themselves once the bankruptcy was dismissed. None of the settlement proceeds would go for wage claims, even though they rank higher in the Bankruptcy Code's priority scheme than the tax claims to be paid.

Holders of the wage claims objected to the settlement and proposed dismissals as violating the priority scheme embedded in Section 507 and circumventing the processes required by the Bankruptcy Code for closing the estate and apportioning its assets among the creditors. The bankruptcy court nevertheless approved the settlement and entered dismissal orders accordingly. In the appeals that followed, the district court and the US Court of Appeals for the Third Circuit both affirmed.

Several months after dismissing the bankruptcy case, the bankruptcy court made certain rulings in the lawsuit arising from the wage claims. It dismissed Sun Capital from that suit as it had not been the employer of the terminated workers. On partial summary judgment, the court found Jevic liable on state-law wage claims that Jevic had not contested. The damages have never been adjudicated.

Legal context

Jevic presents a variant of what are known as 'structured dismissals' of Chapter 11 cases - that is, dismissals that are coupled with one or more forms of affirmative relief or that leave earlier orders of the bankruptcy court in place, rather than returning the parties to the status quo ante. The order dismissing the Jevic bankruptcy was structured to implement the priority-skipping settlement arrangement.

The issues thus arising require an understanding of the Bankruptcy Code's priority scheme, the standards under which claims may be compromised and settled with the approval of the bankruptcy court, and the usual effects of dismissing a Chapter 11 case.

Priorities

Section 507 of the Bankruptcy Code confers priority on certain categories of unsecured claim against the bankruptcy estate and determines the hierarchical order of these priorities. For example, within certain limits, claims for wages, salaries or commissions rank ahead of governmental claims for certain kinds of tax, while claims for the expenses of administration rank above all of these.(3) Section 103(a) provides that Chapter 5 – of which Section 507 is a part – applies in cases under other specified parts of the Bankruptcy Code, including Chapter 7 which addresses the liquidation of bankruptcy estates and Chapter 11 which addresses the rehabilitation or liquidation of bankruptcy estates pursuant to reorganisation plans.

In a Chapter 7 liquidation priority claims are entitled to be paid – in the categorical order dictated by Section 507 – after secured claims but before other unsecured claims. Under Chapter 11 the priority scheme gives rise to the 'best interest of creditors test' codified in Section 1129(a)(7), which requires that a plan must pay unsecured creditors at least as much as they would recover in a Chapter 7 liquidation, unless they agree to less favourable treatment.

Another result of the priority scheme is the 'absolute priority rule', derived from the common law but embedded in Section 1129(b), which determines whether a plan may be 'crammed down' over the objection of an affected class of creditors that has voted to reject it. Under the absolute priority rule, a plan must be "fair and equitable" to the dissenting class.(4) A plan that would pay anything for junior claims cannot pass muster under that standard, unless it would also pay in full all claims within each dissenting class of claims entitled to greater priority.(5)

Compromise and settlement

The administration of bankruptcy estates commonly involves the litigation and resolution of claims assertable for the benefit of the estate, such as causes of action in contract or tort that belonged to the debtor when it filed bankruptcy and fraudulent conveyance claims that the Bankruptcy Code confers on the bankruptcy trustee. When the trustee or debtor in possession proposes to compromise and settle such a claim, Rule 9019 of the Federal Rules of Bankruptcy Procedure conditions such proposals on review and approval by the bankruptcy court upon notice to creditors and other parties in interest.

Rule 9019 prescribes no criteria for evaluating settlements. However, case law establishes that the bankruptcy court is to consider:

"(1) the probability of success in litigation; (2) the likely difficulties in collection; (3) the complexity of the litigation involved, and the expense, inconvenience and delay necessarily attending it; and (4) the paramount interest of the creditors."(6)

This framework derives from a Supreme Court decision handed down almost 50 years ago. Notably, the same precedent teaches that "[t]he requirements… that plans of reorganization be both 'fair and equitable,' apply to compromises just as to other aspects of reorganizations".(7)

Under Rule 9019, is the settlement of an estate claim 'fair and equitable' – words that encompass the absolute priority rule in Chapter 11 – if the settlement provides money for some unsecured claims without first paying in full all claims of higher priority? That question will loom large in the Supreme Court's review of Jevic.

Dismissal or conversion of Chapter 11 case

Section 1112(b) directs the bankruptcy court to dismiss a Chapter 11 case or convert it to a Chapter 7 liquidation ("whichever is in the best interests of creditors and the estate") on a finding of cause, after notice and hearing, if a party in interest so requests.(8) A related provision catalogues on a non-exclusive basis various circumstances that may amount to cause for this purpose, such as the "substantial or continuing loss to or diminution of the estate and the absence of a reasonable likelihood of rehabilitation", the debtor's failure to make required reports or to comply with orders of the court, and the "inability to effectuate substantial consummation of a confirmed plan".(9)

The dismissal of a Chapter 11 case ordinarily restores the parties as much as possible to the legal positions they occupied before the case commenced by:

  • unwinding the bankruptcy estate;
  • revesting property in the entities that held it ex ante;
  • reinstating avoided transfers and liens; and
  • vacating certain kinds of order issued in the course of the aborted case.

The statute qualifies its prescription of these usual effects by the phrase "[u]nless the court, for cause, orders otherwise",(10) but provides no guidance on what kinds of cause may justify deviation from the norm. Is that qualification a narrow concession to the impossibility of perfectly replicating past positions? Or is it instead a broad licence to hold partial outcomes in place when a full bankruptcy resolution is not achievable or desirable?

Commentators have discerned an increasing propensity among bankruptcy courts to vary the effects of dismissal by 'structuring' dismissal orders that include forms of relief that might otherwise be built into a confirmed reorganisation plan, such as provisions:

  • releasing or exculpating parties and professionals that participated in the case;
  • spelling out claims resolution procedures to be applied after the case is dismissed; or
  • approving terms under which secured creditors carve off part of their collateral and confer that value on a junior class of creditors to the exclusion of persons holding more senior claims (a practice known as 'gifting').

The dismissal of the Jevic bankruptcy was structured to implement the distribution of settlement proceeds that skipped over priority claims, even though the proceeds resulted from compromising claims of the estate. The district court affirmed, and the matter then went before the US Court of Appeals for the Third Circuit.

Decision on appeal

A three-judge panel of the Third Circuit split two to one and upheld the bankruptcy court's decision on the grounds that it was permitted by the Bankruptcy Code and made the best of a bad situation:(11)

  • The majority opinion accepted the bankruptcy court's findings that "there was no prospect of a confirmable plan in this case and that conversion to Chapter 7 was a bridge to nowhere". In other words, it took for granted that the unhappy holders of priority claims would not have benefitted from confining the debtor to the processes of Chapter 7 or Chapter 11, since the secured creditors would have been entitled to all value generated in a liquidation and there was no money to fund a rehabilitation effort. With no Chapter 11 plan in the offing, the court distinguished cases in which structured dismissals might have been "contrived to evade the procedural protections and safeguards of the plan confirmation or conversion processes", and held that the bankruptcy court had the discretion to order the disposition that it did, rather than dismissing the case outright without approving the priority-skipping settlement.(12)
  • The majority ruled that the Jevic resolution did not violate the absolute priority rule because the 'fair and equitable' standard, embodied in Section 1129(b)(2)(B)(ii) applies only to reorganisation plans, not settlements. The opinion acknowledged contrary precedent in the Fifth Circuit.(13) But the Jevic majority embraced the more flexible approach taken by the Second Circuit in the only other appellate precedent in point.(14) Under that approach, compliance with the Bankruptcy Code's priority system "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 departure from priorities is not forbidden when "the remaining factors weigh heavily in favor of approving a settlement" and the bankruptcy court provides "specific and credible grounds to justify [the] deviation".(15)
  • Although they deemed it "a close call" and lamented "an element of unfairness," the panel majority endorsed the bankruptcy court's approval of the priority-skipping disposition as "the least bad alternative". They agreed that no "viable alternative existed that would have better served the estate and the creditors as a whole", so that the settlement warranted approval under Rule 9019, even though such a result "is likely to be justified only rarely".(16)

The dissenting judge would have reversed the bankruptcy court's approval of the settlement and structured dismissal as having "undermined the Code's essential priority scheme" and as "an impermissible end-run around the carefully designed routes by which a debtor may emerge from Chapter 11 proceedings".(17) He agreed that a settlement departing from the Bankruptcy Code's priority scheme would be permissible in "extraordinary circumstances", but only if it furthered the goals of bankruptcy by maximising the value of the estate. In the dissenter's view, the plight facing the Jevic parties was not unusual, nor did the settlement enhance the estate; instead, it distributed estate assets (the proceeds of estate causes of action) to a subset of creditors who would have been entitled to nothing in a Chapter 11 process or a Chapter 7 liquidation.(18)

Comment – anticipating Supreme Court review

The Jevic resolution will now come under renewed scrutiny in the Supreme Court.

In their petition successfully invoking this discretionary review, the wage claimants argued that the Bankruptcy Code provides only three exits from Chapter 11:

  • obtain confirmation of a plan that passes muster under all relevant tests, including the absolute priority rule;
  • convert the case to a Chapter 7 liquidation and distribute the proceeds according to the priority scheme; or
  • dismiss the bankruptcy without special structuring, thereby restoring the parties to the status quo ante.(19)

In the merits briefing still to come, the wage claimants will press their point that, when Congress wanted to legislate exceptions to the priority scheme, it did so expressly, as in the superpriority conferred on post-petition lenders under Section 364(d) and the remedy of equitable subordination available under Section 510(a). Accordingly, they will insist, the bankruptcy judge was not free to impose his own view that a settlement and dismissal that provided half a loaf for some junior claims but skipped over priority claims was more equitable than adhering to Bankruptcy Code processes under which no unsecured creditors − junior or senior − would have recovered anything.

These lines of argument have force. Bankruptcy is often a zero-sum game. The priority scheme is a detailed expression of such policy choices made by the legislature. It is hard to see how the self-interest of a secured party and junior creditors in Jevic could validly trump that scheme when the powers of the bankruptcy court were invoked to approve a settlement of estate claims. And of course, more than a discrete settlement was in question: the resolution was designed to dispose of the entire estate and end the Chapter 11 case.

Put differently, why should a bankruptcy court relieve parties of hard choices they confront in the Bankruptcy Code? If the secured party balked at settling Bankruptcy Code-based clawback claims in a way that would have put money in the pockets of workers pursuing priority wage claims against it, why would it have been "nihilistic" − to borrow a phrase from the Third Circuit(20) − to dismiss the bankruptcy without approving the settlement? That outcome would have left the secured party exposed to any remedies the wage claimants could find means to pursue in non-bankruptcy courts. This seems to have been a legitimate bargaining chip for the wage claimants. The bankruptcy judge, the district court and a majority of the Third Circuit panel found it unpalatable for priority claims of debatable merit and uncertain realisable value to prevent more junior claims from achieving a recovery. Yet it was the facts and the Bankruptcy Code – not the priority claims – that put the junior creditors out of the money. By their solicitude for the junior creditors, the lower courts deprived others of rights conferred by the Bankruptcy Code itself.

The Bankruptcy Code is in many ways a flexible statute designed to equip bankruptcy courts to deal with the widely varying and intensely practical problems that stem from insolvency and other forms of financial distress. But the Bankruptcy Code establishes a clear framework for reorganisation and liquidation, and the priority scheme serves as a foundation for both. As a result, parties entering the bankruptcy system know what to expect and can calibrate their positions accordingly. By blurring the picture, the Jevic resolution invites parties to devote their energies 'gaming' bankruptcy cases without fully submitting either to Chapter 11 or Chapter 7, rather than negotiating or litigating within the prescribed framework. In bankruptcy the corollaries of decreased certainty are increased overall cost and greater leverage for participants who have more staying power than their rivals.

Jevic affords the Supreme Court an opportunity to clarify whether strict adherence to the priority scheme is always required for a settlement to win approval under Rule 9019 if a structured dismissal is part of the deal. But no matter whether the Supreme Court chooses to go that far, it is difficult to see how the lower courts' pioneering of bankruptcy resolutions that do not meet the requirements of either Chapter 11 or Chapter 7 can stand up under a strict reading of the Bankruptcy Code. The Supreme Court tends to follow a strict construction approach to Bankruptcy Code matters, and has twice struck down orders of bankruptcy courts that presumed (for ostensible reasons of equity) to override priorities set by the Bankruptcy Code.(21) The Jevic resolution may thus prove to have been no resolution after all.

For further information on this topic please contact Trevor Swett at Caplin & Drysdale by telephone (+1 202 862 5000) or email (tswett@capdale.com). The Caplin & Drysdale website can be accessed at www.capdale.com.

Endnotes

(1) Czyzewski v Jevic Holding Corp, 15-649, 2016 WL 3496769 (US June 28, 2016).

(2) 11 USC Section 507(a)(4). Unless otherwise stated, all statutory references in this article are to the Bankruptcy Code, Title 11 of the US Code.

(3) 11 USC Section 507(a)(4), (8).

(4) Id, Section 1129(b)(1).

(5) See Section 1129(b)(2).

(6) In re Martin, 91 F3d 389, 393 (3d Cir 1996).

(7) Protective Comm for Independent Stockholders of TMT Trailer Ferry, Inc v Anderson, 390 US 414, 424 (1968).

(8) 11 USC Section 1112(b)(1).

(9) Id, Section 1112(b)(3). In a subtly different formulation, Section 305(a) also authorises the bankruptcy court to dismiss a case if the court concludes, after notice and hearing, that "the interests of creditors and the debtor would be better served by such dismissal or suspension". Id, Section 305(a).

(10) Id, Section 349(b).

(11) In re Jevic Holding Corp, 787 F3d 173 (3d Cir 2015).

(12) Id at 181-82; see id at 176, 185.

(13) Matter of AWECO, Inc, 725 F2d 293, 295-96, 298 (5th Cir 1984).

(14) In re Iridium Operating, LLC, 478 F3d 452, 464 (2d Cir 2007). See Jevic, 787 F3d at 183 (following Iridium).

(15) See 787 F3d at 182-84.

(16) Id at 184-85; see id at 186.

(17) Id.

(18) Id at 186-187.

(19) See Petition for a Writ of Certiorari, Czyzewski v Jevic Holding Corp, 15-649, 2016 WL 7252903 at 19 (US Nov 16 2015). The United States supported the petition and urges reversal of the decision below. See Brief for the United States as Amicus Curiae, Czyzewski v Jevic Holding Corp, 15-649 (US May 23 2016).

(20) Jevic, 737 F3d at 185.

(21) United States v Noland, 517 US 535 (1996) (holding that the bankruptcy court could not use equitable subordination under Bankruptcy Code Section 510(c) so as to disregard the statutory priority of a tax penalty that constituted an administrative expense); see also United States v Reorganized CF&I Fabricators of Utah, Inc, 518 US 213 (1996) (ruling that equitable subordination was not available to place a non-priority tax penalty behind other general unsecured claims of equal rank).

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