On Dec. 7, 2016, the U.S. Supreme Court heard oral arguments in Czyzewski v. Jevic Holding Corp, No. 15-659. (S. Ct. argued Dec. 7, 2016).[1] The truckers in Jevic are priority claimants seeking reversal of a Third Circuit ruling that approved a settlement resulting in a structured dismissal of a Chapter 11 case that provided for, among other things, distribution of estate assets contrary to the Bankruptcy Code’s priority scheme.[2] The court’s vigorous and pointed questioning of the litigants indicates the magnitude of Jevic’s significance in the bankruptcy world. The crucial issue in Jevic is the propriety of distributing estate assets outside of the Bankruptcy Code’s priority system, an interpretive task made more difficult by the significant gaps in the code’s statutory text and the practical realities of modern commercial bankruptcy practice. Although the court’s questions at oral argument suggest that the Supreme Court may well reverse the Third Circuit ruling, the implications of such a reversal for bankruptcy practice will depend on the scope of the court’s holding, which is likely to be narrow.

Background

In 2006, Sun Capital Partners purchased Jevic Transportation Corp, a New Jersey trucking company, through a leveraged buyout backed by an $85 million loan financed predominantly by the lender, CIT Group. The trucking company struggled to remain viable for two years, and facing the expiration of a forbearance agreement preventing CIT from foreclosing on Jevic’s assets, the company halted operations, sent termination notices to its employees, and filed for Chapter 11 protection in the District of Delaware the following day.

The dispute before the Supreme Court arose out of two lawsuits filed in Jevic’s bankruptcy case. First, the unsecured creditors committee brought fraudulent conveyance claims against Sun Capital and CIT to avoid the liens that Sun and CIT asserted on Jevic’s assets, arguing that the LBO had hastened Jevic’s bankruptcy by saddling it with debts it could not service. Second, a class of 1,800 truck drivers terminated by Jevic shortly after the petition date sued CIT Bank and Sun Capital for state and federal WARN Act violations. The truck drivers prevailed on their state-law WARN Act claims, and asserted that $8.3 million of their claim qualified as wages under Section 507(a)(4)(1) that were entitled to priority over lower-ranked priority claims and general unsecured claims.

The Settlement and Structured Dismissal

Prior to the litigation of the truck drivers’ WARN Act claims, the unsecured creditors committee, Sun Capital and Jevic began negotiating a settlement to the fraudulent transfer claim. In June 2012, Sun Capital, CIT Bank and the unsecured creditors committee sought court approval of a settlement and structured dismissal, which proposed to wind up Jevic’s bankruptcy case on certain specified terms. Typically, a dismissal of a bankruptcy case under Section 349 simply restores the prebankruptcy status quo and leaves parties to whatever remedies they may have under state law. The “structured dismissal” sought by the movants in Jevic, however, proposed to do far more: settle the fraudulent transfer claims against Sun Capital and CIT and dismiss the fraudulent conveyance action with prejudice; distribute the settlement proceeds among certain administrative priority claimants, tax claimants and general unsecured claimants; approve mutual releases among the settling parties, and then, once these terms were satisfied, dismiss the bankruptcy case. The truck drivers did not consent to the settlement and received nothing on their priority wage claims under the settlement, even though general unsecured creditors were to receive distributions on their lower-priority claims.

Lower Court Rulings

The truck drivers objected to the settlement and structured dismissal because it would distribute estate assets to creditors over whom the truck drivers had priority. The bankruptcy court held that structured dismissals were permissible even though not expressly authorized under the Bankruptcy Code, and that while Chapter 11 plans must satisfy the absolute priority rule, under which an impaired class of dissenting unsecured creditors must be paid in full before a junior class of claimants receives payment, settlements need not follow the absolute priority rule when made outside the context of a plan. The district court affirmed, and the truck drivers appealed to the Third Circuit.

The truck drivers urged the Third Circuit to follow the per se rule adopted by the Fifth Circuit in In re AWECO Inc., 725 F.2d 293 (5th Cir. 1984), in which the court held that the fair and equitable standard applicable to plan confirmation applies to settlements as well.[3] Instead, the court followed the more discretionary standard set forth in In re Iridium Operating LLC, 478 F.3d 452 (2d. Cir. 2007), which held that while compliance with the code’s priority system remains the most important factor for determining whether a settlement is fair and equitable, a settlement may be fair and equitable when application of certain factors “weigh heavily in favor of approving a settlement.”[4]

Oral Argument

The question presented to the Supreme Court by the truckers was “whether a Chapter 11 case may be terminated by a ‘structured dismissal’ that distributes estate property in violation of the Bankruptcy Code’s priority scheme.” Joining the truckers and the respondents at oral argument was the assistant to the solicitor general, who argued in support of the truckers as amicus curae.

Justices Sonia Sotomayor and Samuel Alito questioned the scope of the relief sought. Justice Alito expressed concern that the truckers’ merits brief referred to “structured dismissal,” while the issue in their certiorari petition was whether a bankruptcy court may authorize the distribution of settlement proceeds in a manner that violates the statutory priority scheme. Justice Alito noted that the court granted certiorari on the latter question, over which there is a clear circuit split.[5] The truckers stated that while the unlawful distribution was authorized in the context of a structured dismissal here, the truckers were not asking the court to decide whether structured dismissals are valid — only whether structural dismissals that authorize distribution of settlement proceeds must adhere to the Bankruptcy Code’s priority system.

On that question, the parties and the court wrestled with the absence of statutory language explicitly denying or granting the authority to approve settlements disregarding the absolute priority rule. When the truckers noted that nothing in the code permits the distribution of settlement proceeds in violation of the priority scheme, Justice Breyer responded: “I think you’re right. I don’t see anything that permits it. The problem: what forbids it?” The truckers emphasized that the structure of the Bankruptcy Code created “careful, reticulated mechanisms for the distribution of estate assets,” which Congress did not intend to let courts upend by approving a distribution that violated the statutory priority rules. When Justice Elena Kagan pressed the issue of Congress’ silence on this point, the truckers responded that the code regards settlements as means of liquidating assets for transfer into the estate rather than the distribution of assets to creditors of the estate following liquidation, which a Chapter 11 plan accomplishes. That distinction, according to the truckers, accounts for Congress’ explicit application of priority rules to Chapter 11 plans and corresponding silence with respect to settlements. Dismissals do not provide for the distribution of estate assets either, argued the truckers, as under 11 U.S.C. § 349, dismissal simply “revests the property of the estate in the entity in which such property was vested immediately before the commencement of the case under this title” unless the court, for cause, orders otherwise.

On that point, Justices John Roberts and Anthony Kennedy asked why the “for cause” escape hatch of Section 349 did not allow for the result urged by the respondent. If Chapter 11 cases can only be disposed of through plan confirmation, conversion to Chapter 7, or dismissal, the justices questioned what prevented disposition of Chapter 11 cases through structured dismissals that distributed estate assets to certain creditors when plan confirmation and conversion were unavailable, providing recovery for creditors who would have otherwise received nothing. Citing legislative history, the truckers argued that the “for cause” exception to a dismissal’s returning the parties to their respective positions prior to bankruptcy was intended to maintain the status quo after the bankruptcy case in situations where a party has relied on an action taken during the case, not to provide an end-run for selective distribution of assets to creditors.

The respondent argued that the absolute priority rule applies only to Chapter 11 plans, and that so long as the proponents of a preplan distribution of estate assets are not thereby attempting to evade the requirements for a plan, a court is authorized to review such distributions under the discretionary standard of judicial review used to evaluate the use, sale or lease of property of the estate under Section 363(b). The respondent also insisted that a rule permitting distributions of this kind would apply only in rare situations.

The court seemed skeptical that there was anything “rare” about the situation described by the respondent. Justice Sotomayor observed that “every structured settlement of this kind is trying to exclude one set of creditors.” Justice Kennedy mused that there is certainly nothing rare about administratively insolvent Chapter 11 cases that cannot produce a confirmable plan. Justice Kagan asked whether bankruptcy courts must follow the priority system when distributing assets in such cases, or whether — if there is a solution that leaves some parties better off and no party worse off — a bankruptcy court can implement such a solution, even if it violates the statutory priority scheme. Such a result might be a completely sensible provision for Congress to have enacted, said Justice Kagan, but the question is whether Congress did enact it. Justice Kagan appeared unconvinced that Congress intended such an exception to the statutory priority scheme: “Where is the authorization for that in the Bankruptcy Code? Because that’s like a big principle ... I think we would have known about it if that’s the way bankruptcy proceedings were supposed to go.”

Justice Stephen Breyer agreed, asking why Congress, which had carefully crafted an ordered and detailed system for distributing assets, would permit a bankruptcy trustee or court to reverse that order.[6] The respondent countered that Section 363(b)’s discretionary test would weed out bad faith or collusive distributions, but Justice Breyer expressed serious doubts about the propriety of empowering bankruptcy courts to approve distributions of assets contrary to Congress’ scheme, even if good faith were assured, noting that it “seemed a dangerous principle to get into.”

While the Supreme Court appeared inclined to reverse the Third Circuit’s ruling, the scope of the Supreme Court’s ruling remains an open question. The court and the parties seemed well aware of the far-reaching implications that a broad holding could have on Chapter 11 practice.

Justice Alito asked the truckers if they were arguing that “there can never be a distribution of estate assets except in compliance with the priorities.” Such a holding would cast doubt on the validity of numerous common Chapter 11 practices, including first-day wages orders and critical vendor payments. The truckers said that the court need not reach these issues, and distinguished critical vendor payments, which are premised on maximizing the going-concern value of the business, from favoring junior creditors over senior creditors for its own sake in the context of a liquidation, which the truckers argued is never permitted. This exchange suggests that the court, though clearly inclined to reverse the circuit court’s opinion, may do so in an opinion narrowly focused on the permissible scope of dismissal orders so as not to jeopardize the continuing use of critical vendor motions and other Chapter 11 practices aimed to preserve and enhance the going-concern value and operations of Chapter 11 debtors.

Republished with permission. This article first appeared in Law360 on December 16 2016.