The Supreme Court again will be addressing the powers of bankruptcy courts. At the end of the term, the Court granted certiorari in Czyzewski v. Jevic Holding Corp. to decide whether a bankruptcy court may authorize the distribution of settlement proceeds in a way that violates the statutory priority scheme in the Bankruptcy Code. No. 15-649, 2016 WL 3496769 (S. Ct. June 28, 2016). The Supreme Court is expected to address this fundamental bankruptcy issue sometime early next year.

Background

Jevic Transportation was a New Jersey-based trucking company. In 2006, Sun Capital Partners, a private equity firm, acquired the company in a leveraged buyout. Sun Capital financed the transaction by borrowing against Jevic’s assets. Shortly thereafter, Jevic refinanced the debt it had incurred pursuant to the buyout with a consortium of lenders led by CIT Group. By late 2007, Jevic had defaulted on this loan. Jevic then filed for chapter 11 bankruptcy protection on May 20, 2008.

A class of nearly 1800 truck drivers, whom Jevic laid off without warning near the time of the bankruptcy, brought suit against both Jevic and Sun Capital. The official committee of Jevic’s general unsecured creditors also brought suit on behalf of Jevic’s estate against Sun Capital and CIT Group, arguing that the leveraged buyout was a preference and fraudulent transfer. As Jevic was administratively insolvent—i.e., the administrative and priority claims against the estate exceeded the value of the estate’s unencumbered assets—it pursued a settlement of the estate’s claims and a structured dismissal that would distribute the proceeds among creditors.

In June 2012, Jevic, Sun Capital, CIT and the unsecured creditors committee filed a joint motion seeking court approval of a proposed settlement and structured dismissal. Under the settlement: (i) CIT agreed to pay $2 million on account of various administrative priority claims; (ii) Sun Capital agreed to assign its lien on Jevic’s remaining $1.7 million in cash to a trust to pay other administrative and tax claims, and then to pay the general unsecured claims on a pro rata basis; (iii) the parties agreed to dismiss the fraudulent transfer action and the bankruptcy case; and (iv) the settling parties agreed to release all claims against each other.

The class of laid off drivers and the U.S. Trustee (an officer of the Department of Justice) each objected to the settlement and structured dismissal. The drivers had priority claims against the estate under sections 507(a)(4) and (5) as a result of Jevic’s violations of the New Jersey equivalent of the Worker Adjustment and Retraining Notification Act (better known as the WARN Act). The drivers argued that the settlement violated the priority scheme under 11 U.S.C. § 507 and improperly channeled a recovery to general unsecured creditors before paying their priority claims in full. The drivers further contended that the unsecured creditors committee had breached its fiduciary duty to the estate by “agreeing to a settlement that, effectively, freezes out the [drivers].” Additionally, the U.S. Trustee objected on the ground that the Bankruptcy Code does not permit structured dismissals.

Jevic, Sun Capital and CIT responded by arguing that section 507 does not apply to settlements, including structured dismissals like the one at issue here. “Section 507 of the Code simply describes the priority of particular ‘expenses and claims.’ … It does not specify the circumstances under which bankruptcy courts are required to apply those priorities.” Section 1129 in turn applies this scheme but only in the context of a plan. Accordingly, the parties argued that section 507 has no bearing on a settlement.

Analysis

Section 507 of the Bankruptcy Code details the priority order of the payment of certain claims when assets of the bankruptcy estate are distributed. In particular, section 507(a)(4) requires payment of $12,475 per employee in wages and compensation. Under section 507(a)(5), the debtor must pay claims contributions to an employee benefit plan arising from services rendered within 180 days of the petition date (in amount totaling $12,475 per employee covered under the benefit plan).

Prior to Jevic, two Courts of Appeals grappled with whether or not distributions of settlement proceeds must comply with section 507. In In re AWECO, Inc., the Fifth Circuit rejected a settlement of a lawsuit against a chapter 11 debtor that would have transferred $5.3 million worth of estate assets to an unsecured creditor before satisfying outstanding senior claims. 725 F.2d 293 (5th Cir. 1984). The Fifth Circuit held that settlements must be “fair and equitable,” and that “fair and equitable” means compliant with the priority scheme.

The Second Circuit adopted a more flexible approach when confronted with the same question several years later. In In re Iridium Operating LLC, 478 F.3d 452 (2d Cir. 2007), the unsecured creditors committee proposed a settlement that would split the estate’s cash between the lenders and a litigation trust set up to fund a different debtor action against one of the priority administrative creditors. The priority administrative creditor objected to the settlement because the proposed distribution allocated funds to lower-priority creditors and skipped over the administrative claim. Finding the Fifth Circuit’s approach in AWECO, Inc. “too rigid,” the Second Circuit concluded that the absolute priority rule is not necessarily implicated when a court is asked to approve a settlement outside the context of a reorganization plan. Although complying 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,” the Second Circuit held that courts may nonetheless approve settlements with distributions deviating from the priority structure when “the remaining factors weigh heavily in favor of approving a settlement[.]”

Delaware Bankruptcy Court and District Court Opinions in Jevic

In an oral opinion, the Bankruptcy Court for the District of Delaware approved the proposed Jevic settlement and entered the structured dismissal. The court held that the Bankruptcy Code does not expressly authorize structured dismissals, but it found them permissible because they are “simply dismissals that are preceded by other orders of the bankruptcy court … that remain in effect after dismissal.” It also found section 507 inapplicable because the case did not involve a chapter 11 plan. The bankruptcy court stated that it had the power approve the structured dismissal under section 105(a) of the Bankruptcy Code—which gives it the power “to issue any order … that is necessary or appropriate to carry out the provisions” of the Bankruptcy Code—because it was more appropriate than the alternative of converting the case to chapter 7.

The bankruptcy court applied the multifactor test of In re Martin, 91 F.3d 389 (3d Cir. 1996) used for evaluating settlements under Federal Rule of Bankruptcy Procedure 9019. Under this test, a bankruptcy judge must consider the following in deciding whether to approve a proposed compromise: (1) probability of success in litigation; (2) likely difficulties in collection; (3) complexity of litigation involved, and expense, inconvenience and delay necessarily attending it; and (4) paramount interest of creditors. The Jevic court balanced these factors and found that the balance tipped in favor of approving the settlement, and nothing in the Bankruptcy Code dictated otherwise.

The district court affirmed. The court found that the bankruptcy court had not abused its discretion in concluding that structured dismissals are permissible, and that the settlement did not need to follow the absolute priority rule because it was not a reorganization plan. In re Jevic Holding Corp., No. 08-11006, 2014 WL 268613 (D. Del. Jan. 24, 2014).

Third Circuit Opinion in Jevic

A divided panel of the Third Circuit affirmed. In re Jevic Holding Corp., 787 F.3d 173 (3d Cir. 2015). Like the lower courts, the Third Circuit’s decision ultimately turned on the fact that the absolute priority rule as codified under section 1129(b)(2) applies by its terms only to plans, and that there is no specific Code provision prohibiting distributions that bypass the priority scheme outside the plan context. In so holding, the Third Circuit expressly rejected the Fifth’s Circuit holding in AWECO, Inc. and, instead, adopted the Second Circuit’s holding in Iridium Operating.

The Third Circuit began its analysis by noting that settlements are favored in bankruptcy. It also expressly agreed with the Second Circuit’s statement that “compliance with the Code priorities will usually be dispositive of whether a proposed settlement is fair and equitable.” The Third Circuit therefore 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 deviation.” Noting that Jevic presented a “close call,” the Court ultimately found “specific and credible grounds” for approving the settlement because it presented “the least bad alternative” where 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.”

Judge Scirica dissented. He stated that approving the settlement “undermined the Code’s essential priority scheme… by skip[ping] over an entire class of creditors” in making distributions. While he did not advocate for a per se rule similar to the one made in AWECO, Inc., he did not find the circumstances in Jevic extraordinary enough to warrant an exception. Instead, he deemed the settlement “an impermissible end-run around the carefully designed routes by which a debtor may emerge from Chapter 11 proceedings.”

Supreme Court Considerations

There is a strong textual argument for affirming the Third Circuit’s opinion given the lack of provisions in the Bankruptcy Code dictating that priorities apply to settlements, as opposed to plans. While the absolute priority rule is critical to the bankruptcy scheme, under the plain text of the Bankruptcy Code, only plans need comply with it.

The Solicitor General, together with the Executive Office for the U.S. Trustee, weighed in on this matter with an amicus brief. The Solicitor General recommended granting review and argued that the Third Circuit should be reversed. The Solicitor General’s brief rejected reading the statutory priorities as limited to plans, contending that “bankruptcy is not a free-for-all in which parties or bankruptcy courts may dispose of claims and distribute assets as they see fit.” Much like Judge Scirica, the Solicitor General saw a settlement as essentially a substitute for a plan, which needs to comply with the priority scheme under section 507.

Impact

The Supreme Court’s decision will, hopefully, resolve one of the most important circuit splits in business bankruptcy law. Currently, the Third Circuit’s decision enables parties to reach settlements that do not comply with the priority scheme under section 507. Given the strong policy favoring consensual agreements and the balance of factors weighing in favor of settlement approval under Martin, affirming the Third Circuit’s decision may be consistent with Congress’ intent. A ruling in favor of structured dismissals would serve to channel cases away from chapter 11 plans and toward consensual settlements. This could reduce administrative costs and facilitate quicker bankruptcy resolutions. However, this could also lead to settlements that run counter to the expected results under the absolute priority rule. This represents a close and complex question for the Court.

Additionally, the Supreme Court’s decision may affect the permissibility of “gift plans,” i.e. payments from secured creditors or buyers—supposedly from their own property—that enable distribution in a chapter 11 plan not in accordance with priorities. If the Supreme Court signs off on orders where creditors agree to recoveries outside the scope of the absolute priority rule, it might tacitly endorse gift plans whereby secured creditors agree that their recoveries may be distributed in part to junior creditor classes to ensure completion of the bankruptcy. Historically, gifting has occurred in the plan context, but structured dismissals could also provide a platform for this activity.

The oral argument date for Jevic has not been set yet. We expect that it will be held in early December of this year.