Third Circuit Upholds Structured Dismissal, Despite Deviation From Bankruptcy Code’s Priority Scheme

In a recent decision, the United States Court of Appeals for the Third Circuit upheld the structured dismissal of a Chapter 11 case despite the fact that it provided for distributions to creditors that deviated from the priority scheme established under the Bankruptcy Code. Under section 349(b) of the Bankruptcy Code, unless the court orders otherwise for cause, dismissal of a case vacates any orders entered by the bankruptcy court and restores the parties to their positions prior to the bankruptcy filing. In a structured dismissal, rather than simply restoring the parties to their prior positions upon dismissal, the court imposes certain terms and conditions which have been agreed to by the parties when the case is dismissed. Such terms can include approvals of settlements and releases, and how monies are to be distributed to creditors. But, can such terms imposed upon a structured dismissal include distributions of estate property that deviate from the priority system established under the Bankruptcy Code? That was the issue confronted by the Third Circuit In re Jevic Holding Corp.,1 where the court held that a structured dismissal could deviate from the Bankruptcy Code’s priority scheme “in a rare case.”

Background

Jevic was a trucking company headquartered in New Jersey that in 2006, after its business had already begun to decline, was acquired in a leveraged buyout by a subsidiary of the private equity firm Sun Capital Partners. The LBO was financed by a group of lenders led by CIT Group, which extended an $85 million revolving credit facility to Jevic. After struggling for another two years, Jevic ceased substantially all of its operations, and provided its employees with notice of their impending terminations on May 19, 2008. The next day, Jevic filed a voluntary Chapter 11 petition in the United States Bankruptcy Court for the District of Delaware. As of the petition date, Jevic owed about $53 million to its first-priority senior secured creditors (CIT and Sun) and over $20 million to its priority tax and general unsecured creditors.

Thereafter, two lawsuits were filed in the Bankruptcy Court which were germane to the issues before the Third Circuit. A group of Jevic’s terminated truck drivers filed a class action against Jevic and Sun alleging violations of federal and state Worker Adjustment and Retraining Notification (WARN) Acts, under which Jevic was required to provide 60-days’ written notice to its employees before laying them off. Ultimately, the WARN Act claim was upheld against Jevic, but not Sun.2 The drivers never had the opportunity to establish damages, but they estimated that their claim was worth $12.4 million, of which $8.3 million was a priority wage claim under Section 507(a)(4), which is entitled to higher priority than priority tax claims.3

The Creditors’ Committee brought a fraudulent conveyance action on the estate’s behalf against CIT and Sun, alleging that Sun, with CIT’s assistance, hastened Jevic’s bankruptcy by saddling it with debts that it could not service. Several years later the Bankruptcy Court granted in part and denied in part CIT’s motion to dismiss the fraudulent conveyance lawsuit.

By March 2012, when the parties met to try to settle, all of Jevic’s tangible assets had been liquidated to repay the lender group led by CIT, and all that remained in the estate was $1.7 million in cash (which was subject to Sun’s lien) and the fraudulent conveyance action. The Committee, Jevic, CIT and Sun reached a settlement to be implemented under a structured dismissal that contained four elements. First, those parties would exchange releases of their claims against each other and the fraudulent conveyance action would be dismissed with prejudice. Second, CIT would pay $2 million into an account earmarked to pay legal fees of Jevic and the Committee and other administrative expenses. Third, Sun would assign its lien on Jevic’s remaining $1.7 million cash to a trust, which would pay tax and administrative creditors first and then the general unsecured creditors on a pro rata basis. Fourth, the Chapter 11 case would be dismissed. Notably, the Drivers’ priority wage claim, which enjoyed higher priority than the priority tax claims and the general unsecured claims, would not receive any distribution under the structured dismissal. It was not clear from the record before the Third Circuit why the drivers had been excluded from the settlement.

The drivers and the United States Trustee objected to the proposed settlement and structured dismissal primarily because it distributed property of the estate to creditors of lower priority. The Bankruptcy Court approved the settlement, and the United States District Court for the District of Delaware upheld such approval on appeal.

The Third Circuit’s Analysis

Circuit Judge Hardiman, who wrote the majority opinion, began by observing that Federal Rule of Bankruptcy Procedure 9019 expressly authorizes settlements as long as they are “fair and equitable.” The four factors for approving settlements in the Third Circuit are: “(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.”4 The drivers did not contend that the Bankruptcy Court erred in concluding that the balance of these factors favored settlement, and the Third Circuit agreed, noting that the Committee’s fraudulent conveyance suit was far from compelling, especially in light of defendants’ substantial resources and the Committee’s lack thereof.

Instead, the drivers argued that structured dismissals are not authorized by the Bankruptcy Code, and if they are permissible then they must not deviate from the priority system established under the Bankruptcy Code. Judge Hardiman conceded that the Bankruptcy Court does not expressly authorize structured dismissals. However, while dismissal under Section 349(b) will “typically reinstate the pre-petition state of affairs by revesting property in the debtor and vacating orders and judgments of the bankruptcy court, it also explicitly authorizes the bankruptcy court to alter the effect of dismissal ‘for cause’ – in other words, the Code does not strictly require dismissal of a Chapter 11 case to be a hard reset.”5

The drivers took the position that the lower courts had “overestimate[d] the breadth of bankruptcy courts’ settlement-approval power under Rule 9019, ‘render[ing] plan confirmation superfluous’ and paving the way for illegitimate sub rosa plans engineered by creditors with overwhelming bargaining power.”6 The majority opinion rejected this argument, noting that: “But even if we accept all that as true, the Drivers have proved only that the Code forbids structured dismissals when they are used to circumvent the plan confirmation process or conversion to Chapter 7. Here, the Drivers mount no real challenge to 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. … [A]bsent a showing that a structured dismissal has been contrived to evade the procedural protections and safeguards of the plan confirmation or conversion processes, a bankruptcy court has discretion to order such a disposition.”7

Next, the Third Circuit rejected the drivers’ argument that, even if structured dismissals are permissible, they cannot be approved if they distribute estate assets in derogation of the priority scheme of Section 507. The majority noted that the Supreme Court had held that “the “requirement[] . . . that plans of reorganization be both ‘fair and equitable,’ appl[ies] to compromises just as to other aspects of reorganizations.”8 The fair and equitable standard incorporates the absolute priority rule under which creditors and stockholders may only participate in distributions of estate property in accordance with their respective priorities. However, Judge Hardiman concluded that the absolute priority rule, which is codified in Section 1129(b)(2), only applied in the plan confirmation process, not approval of settlements.

The Third Circuit then noted a split between the Second and Fifth Circuits on whether the priority scheme of Section 507 must be followed when settlement proceeds are distributed in Chapter 11 cases.9 The majority adopted the more flexible approach of the Second Circuit, holding 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 that deviation, and noting that compliance with the Code priorities will usually be dispositive of whether a proposed settlement is fair and equitable. Judging the deal before it under that standard, the Third Circuit upheld the settlement and structured dismissal because it was “the least bad alternative since 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.’”10

The dissenting opinion noted that the settlement and structured dismissal raised the same concerns as transactions invalidated under the sub rosa plan doctrine.11 The dissent also viewed as critical the fact that the money paid to the junior creditors by the senior lenders was property of the debtor’s estate, as was the cause of action that was settled in exchange for releases. Thus, the dissent distinguished so-called “gifting” cases where a senior lender gives its own property to a junior class, while skipping an intermediate class.12

Implications

In recent years, many companies that have landed in Chapter 11 have been burdened with secured debts that exceed the value of the company’s assets. This has created tremendous tension among creditor constituencies, with senior lenders seeking a prompt resolution to preserve scarce value and creditors who are ostensibly out of the money pursuing alternate forms of recovery. If in fact all assets are encumbered and the senior lenders are underwater, then technically a plan of reorganization cannot be confirmed because, unless senior lenders waive their rights to some assets, there are no free funds to pay administrative and priority claims (although sometimes courts have waived this requirement). Parties can use Section 363 to sell the business as a going concern, and then convert the case to a Chapter 7 liquidation. However, that approach is often disfavored by senior lenders and managers because it will entail the appointment of a bankruptcy trustee who may assert litigation claims against the senior lenders and insiders who are necessary for a prompt disposition of the assets. Therefore, in over-levered cases, parties often seek alternative resolutions to maximize going concern value, avoid protracted litigation, spare expense and tie up loose ends.

Parties have availed themselves of a number of tools to resolve roadblocks that may arise in over-levered Chapter 11 cases, including prepacks, pre-negotiated cases, restructuring support agreements, quick Section 363 sales followed by a liquidating plan, gifting plans or other mechanisms to garner enough consensus to achieve confirmation or a sale of assets before scarce estate assets are squandered. In light of the Jevic decision, it is likely that structured dismissals will become more prevalent, at least in the Third Circuit, thereby providing another mechanism to resolve over-levered Chapter 11 cases.

However, as even the majority opinion noted, structured dismissals that deviate from the priority scheme of Section 507 are problematic, and should only be allowed in “rare” circumstances. It remains to be seen what circumstances will qualify as rare. Saving a business may provide justification for deviating from the Code’s priority scheme, but in Jevic there was no longer an operating business that might have been adversely affected by the inability to confirm a plan. The court believed that deviation was justified because a deal that provided money to some junior creditors (even outside the order of priorities) was a better outcome than senior lenders taking everything. Yet, there is no reason why the $3.7 million set aside for junior creditors could not just as easily have been distributed in accordance with the Code’s priority scheme (other than the fact that the more junior creditors were the ones at the bargaining table).

Moreover, if the court had adopted a strict standard requiring full compliance with the absolute priority rule upon dismissal, then parties would know that any settlement had to avoid skipping intermediate priorities. In fact, while the Third Circuit opined that “the Code forbids structured dismissals when they are used to circumvent the plan confirmation process or conversion to Chapter 7,” it appears that the settling parties in Jevic used a structured dismissal to do just that.

It is also problematic that the value contributed by the senior creditors was in exchange for releases against estate causes of action, a characteristic often shared by gifting plans. If litigation claims that belong to the estate are settled by an estate representative in a Chapter 11 or Chapter 7 case, then the proceeds thereof must be distributed to creditors in order of priority. It is not clear why simply dismissing the case can allow parties to evade those requirements, especially where there is less transparency and fewer creditor safeguards upon dismissal. These issues will likely be fleshed out in future cases where parties use structured dismissals to resolve over-levered estates.

For More Information

For more information on how these issues may affect your rights, contact Nicholas F. Kajon at 212.537.0403.

This News Alert has been prepared for informational purposes only and should not be construed as, and does not constitute, legal advice on any specific matter. For more information, please see the disclaimer.

1 No. 14-1465, __ F.3d __, 2015 WL 2403443 (3rd Cir. May 21, 2015).
2 For a discussion of parent company exposure to WARN Act claims, see Kajon, Second Circuit Warns Equity Investors On WARN Act Exposure, December 17, 2013, available at http://www.stevenslee.com/second-circuit-warns-equity-investors-on-warn-act-exposure/.
3 Damages under the WARN Act qualify for priority wage claim status under Section 507(a)(4).
4 Slip Op. at 14, quoting In re Martin, 91 F.3d 389, 393 (3d Cir. 1996).
5 Slip Op. at 17.
6 Id.
7 Id. at 17-18.
8 Id. at 19, citing Protective Comm. for Indep. Stockholders of TMT Trailer Ferry, Inc. v. Anderson (TMT Trailer Ferry), 390 U.S. 414, 424 (1968).
9 Slip Op. at 20-22, comparing Matter of AWECO, Inc., 725 F.2d 293 (5th Cir. 1984) (rejecting a settlement that skipped higher priority claims; “fair and equitable” standard applies to settlements, and “fair and equitable” means compliant with the priority system), with In re Iridium Operating LLC, 478 F.3d 452 (2d Cir. 2007) (the absolute priority rule “is not necessarily implicated” when a settlement is presented for court approval apart from a reorganization plan; “whether a particular settlement’s distribution scheme complies 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,” but a noncompliant settlement could be approved when “the remaining factors weigh heavily in favor of approving a settlement;” but remanding the case for consideration of one of two priority scheme deviations).
10 Slip Op. at 24.
11 Dissent at 4, citing In re Braniff Airways, Inc., 700 F.2d 935, 940 (5th Cir. 1983) (rejecting an asset sale that “had the practical effect of dictating some of the terms of any future reorganization plan”).
12 Dissent at 6, citing In re SPM Manufacturing Corp., 984 F.2d 1305 (1st Cir. 1993); In re World Health Alternatives, 344 B.R. 291 (Bankr. D. Del. 2006). For a discussion of gifting plans, see Kajon, Second Circuit Holds “Gifting” Plan Violates Absolute Priority Rule and Disregards Blocking Vote Cast by Competitor Attempting to Take Control of Debtor, February 17, 2011, available at http://www.stevenslee.com/second-circuit-holds-gifting-plan-violates-absolute-priority-rule-and-disregards-blocking-vote-cast-by-competitor-attempting-to-take-control-of-debtor/.

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