Last week the Second Circuit issued its long-awaited opinion on the appeals of plan confirmation taken by the first lien, 1.5 lien and subordinated noteholders in In re MPM Silicones, LLC (“Momentive”).   With one exception, the Court determined that the plan confirmed by the bankruptcy court in September 2014 comports with Chapter 11 of the Bankruptcy Code.  The Court remanded to the bankruptcy court in order to address the process for determining the proper interest rate under the cramdown provision of Chapter 11.

The Bankruptcy Code allows debtors to issue replacement notes pursuant to which deferred cash payments are made to secured creditors, but ultimately these payments must amount to the full value of the secured creditors’ claims.  In order to ensure that the creditor receives the full present value of its claim, the payments must carry the appropriate rate of interest.  In this case, the bankruptcy court applied an interest rate based on the “formula” approach, and selected interest rates of 4.1% and 4.85% for the first lien and 1.5 lien notes, respectively.  It was undisputed that these rates were below market, but the debtors asserted that this method was required by the Supreme Court’s plurality opinion in the Chapter 13 case Till v. SCS Credit Corp., 541 U.S. 465 (2004).

The Second Circuit adopted the Sixth Circuit’s two-step approach in setting the cramdown interest rate on the replacement notes.  Under this approach, the bankruptcy court must (i) ascertain whether there exists an efficient market and if so, apply a market rate of interest to the replacement notes or (ii) if no such efficient market exists, the court should then employ the formula approach which begins with the national prime rate and takes into account other factors, which was endorsed by the Supreme Court in Till. 

Although the Second Circuit remanded the case to the bankruptcy court to determine which rate should be used, the Court noted that the senior noteholders presented expert testimony in the bankruptcy court that, if credited, would have established a market rate in the 5-6+% range.

In addition, the Second Circuit expressly rejected the analysis of the Third Circuit in the Energy Future Holdings case regarding the enforceability of “make-whole” premiums in bankruptcy.  As noted in a previous post, available here, the Third Circuit Court of Appeals held that the debtor could not use a voluntary Chapter 11 bankruptcy filing to escape liability for a “make-whole” premium if express contractual language required such payment when the borrower makes an optional redemption prior to a date certain.  The Second Circuit has taken the opposite position, finding that the petition date becomes the maturity date for outstanding notes, such that they were not repaid ahead of time and therefore not entitled to the make-whole premium.

The Second Circuit also rejected the subordinated noteholders’ arguments that they should have been repaid before a group of second-lien noteholders, determining that although the documentation was ambiguous, it did provide for the repayment of the second-lien holders ahead of the subordinated notes.  Further, the panel disagreed that the appeals should have been dismissed as equitably moot, finding that given the scale of the debtors’ reorganization, the possibility that the debtors may be required to provide, at most, $32 million of additional annual payments over the next seven years, depending upon the bankruptcy court’s analysis, would not unravel the plan or threaten the debtors’ emergence.

In In Re Lexington Hospitality Group, LLC, the United States Bankruptcy Court for the Eastern District of Kentucky thwarted a lender’s efforts to control whether its borrower could file bankruptcy. As a condition to the loan, the lender mandated that the borrower’s operating agreement have certain provisions that require the affirmative vote of an “Independent Manager” and 75% of the members to authorize a bankruptcy. The lender also included a failsafe veto provision that prohibited the borrower from filing for bankruptcy without the advance, written affirmative vote of the lender even if the borrower had obtained the vote of the Independent Manager and 75% of the members.

Janee Hotel Group formed Lexington Hospitality Group (LHG) and acted as its manager. Under LHG’s original operating agreement, Janee managed the business and affairs of LHG. The operating agreement did not address bankruptcy.

Janee acquired a hotel with acquisition financing provided by PCG Credit Partners (PCG). In connection with the loan, LHG amended its operating agreement to admit a 30% member, 5532 Athens, which PCG owned. LHG also admitted two additional members totaling 10%, thereby reducing Janee’s ownership interest to 60%.

PCG also required LHG to include certain “Bankruptcy Restrictions” in its operating agreement, to wit: LHG may declare bankruptcy only so long as an “Independent Manager” authorizes such action, and then only upon a 75% vote of the members. The Independent Manager’s role was restricted to participating in bankruptcy matters and, when considering such matters, was required to weigh the costs/benefits of the decision on LHG, LHG’s creditors and 5532 Athens. Additionally, the operating agreement prevented LHG from filing bankruptcy “without the advance, written affirmative vote of [PCG] and all members of [LHG].”

Eventually, LHG filed for bankruptcy without satisfying the above requirements. Instead, Janee, as the sole manager of LHG, signed the filing resolution, which contained no vote by the Independent Manager or the other members, nor had LHG obtained PCG’s “advance, written affirmative vote” for the filing.  PCG moved to dismiss the bankruptcy as unauthorized.

The court recognized that state law governs whether LHG is authorized to file for bankruptcy, but federal law governs whether the Bankruptcy Restrictions are enforceable as a matter of public policy. Generally, parties have the freedom to agree to the terms of an operating agreement; however, attempts to contract away the right to file for bankruptcy generally are unenforceable.

Here, the court found that Kentucky law authorized LHG to file bankruptcy, since filing bankruptcy is a business decision connected to the business affairs of a company and within the expansive decisional authority reserved to managers under the Kentucky limited liability company act. Turning to the Bankruptcy Restrictions, the court noted that LHG included these provisions in its operating agreement only because PCG required them as a condition to loan. The court found that the inclusion of an Independent Manager was “merely a pretense to suggest that the right to file bankruptcy is not unfairly restricted.” While “[a] requirement that an independent person consent to bankruptcy relief, property drafted, is not necessarily a concept that offends federal public policy,” limiting the independence of that manager is problematic. One such limitation was that the Independent Manager needed to consider the interest of creditors and 5532 Athens when deciding on bankruptcy, a restriction that abrogated the Independent Manager’s fiduciary duty to LHG. Another constraint on the  Independent Manager’s ability to act independently was that, notwithstanding the Independent Manager’s vote for bankruptcy, a properly authorized filing still required a 75% member vote that could not be achieved without the vote of 5532 Athens (which was controlled by PCG).  Moreover, the Independent Manager requirement ceased once LHG repaid the loan, clearly tying the Independent Manager to PCG and further eroding its “independence.” Thus, the court concluded that the Independent Manger provisions were not adequately drafted to preserve the Bankruptcy Restrictions.

The court also took issue with the requirement that PCG consent to any LHG bankruptcy. Most troubling was that “PCG [had] no restrictions and no fiduciary duties to LHG that might limit self-interested decisions that ignore the best interest of [LHG].” The court, therefore, held that the Bankruptcy Restrictions as a whole “serve[d] only one purpose: to frustrate LHG’s ability to file bankruptcy;” and accordingly, were unenforceable.

Bankruptcy is a risk of doing business. Courts will scrutinize documents that purport to limit a borrower’s ability to utilize bankruptcy as a business strategy. Such limitations are rarely, if ever, countenanced. Lenders must understand this risk and underwrite accordingly.

The Delaware bankruptcy court recently decided that a debtor could not assign a trademark license absent the consent of the licensor.  The court concluded that federal trademark law and the terms of the license precluded assignment without consent.  Because the debtor could not assign the license under any circumstances (consent was not forthcoming), the court held that cause existed to annul the automatic stay to permit the licensor to “move on with its trademark and its business.”

The debtors (Rupari) engaged in the manufacture, sale and distribution of frozen meat products.  The licensor (Roma) granted Rupari a trademark license to use the “Tony Roma” mark.  After claiming a breach by Rupari, Roma purported to terminate the license.  Rupari denied any breach, asserted that Roma’s efforts to terminate the license were ineffective, and eventually filed for bankruptcy.

Immediately after its bankruptcy filing, Rupari sought to sell substantially all of its assets.  The sale provided that the assignment of the Roma license was a closing condition.  Rupari also filed a declaratory judgment action seeking to have all license termination efforts declared void.  Roma objected to the sale on the grounds that it had terminated the license prepetition (and therefore Rupari had no license to assign), and alternatively, if the license was intact, Rupari could not assign the license because Roma would not consent.  While this skirmish was pending, Rupari revised its sale agreement to remove the assignment of the license as a closing condition and reduced the purchase price by $2 million.  Rupari then dismissed the lawsuit.

Shortly after dismissal of the lawsuit, Roma issued a press release announcing that it had entered into a new exclusive licensing arrangement for its Tony Roma mark.  Rupari reacted by filing a second lawsuit seeking a determination that Roma had willfully violated the automatic stay and renewing the declaratory judgment issues.  A few weeks later, the court approved the Rupari sale without assignment of the license.

In considering the second lawsuit, the court cited federal trademark law for the general position that a non-exclusive trademark license cannot be assigned absent express authorization from the licensor.  Rupari stressed that the license agreement modified this general rule since the parties previously had amended the Roma license to replace strict anti-assignment language with a provision that permitted assignment of the license (a) by operation of law or (b) in connection with a sale of all or substantially all assets but only with the other party’s consent, which could not be unreasonably withheld.

Focusing on the latter provision, Rupari argued that Roma’s refusal to consider “well-qualified prospective bidders” as assignees of the license breached the “consent not unreasonably withheld” requirement. While perhaps a meritorious position in some circumstances, the court found Rupari had effectively mooted the argument by closing the sale (without the license) before resolving the assignment issues. Because the license was not being assigned “in connection with a sale,” the consent issue was not implicated. Accordingly, citing Third Circuit precedent, the court held that because there were no circumstances under which Rupari could now assign the license, “cause” existed to annul the automatic stay to permit Roma to proceed with licensing its trademark to another licensee.

Exculpation provisions in operating agreements must be carefully crafted in order to protect members, managers, directors and officers for breaches of fiduciary duties. In In re Simplexity, LLC, the Chapter 7 trustee sued the former officers and directors (who were also members and/or managers) for failing to act to preserve going concern value and exposing the debtors to WARN Act claims.  The defendants argued the exculpation language in the operating agreements shielded against breach of fiduciary duty liability.  The Delaware bankruptcy court found that the plain language of the applicable operating agreement did not protect the defendants from liability for breach of fiduciary duty; therefore the members, officers and directors could be liable for damages.

Under Delaware law, charter documents, such as a limited liability company operating agreement, can reduce or eliminate fiduciary duty liability for managers and controlling members of limited liability companies. The intent to reduce or eliminate such liability, however, must be “plain and unambiguous.”  In the absence of plain and unambiguous intent, managers and controlling members owe fiduciary duties.  To ascertain whether such intent was present in the Simplexity case, the court began where it must, with the language of the operating agreements.

If you want exculpation, be explicit.

The relevant provisions of the Simplexity operating agreement (Simplexity Agreement) provided:

Limitation on Liability. No current or former Manager of [Simplexity] shall be personally liable to the Company or the Member for monetary damages for breach of fiduciary duty as a Manager of [Simplexity]…provided, however, that this provision shall not eliminate liability of a Manager (i) for any breach of the Manager’s duty of loyalty to the Company and the Member, (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law, or (iii) for any transaction from which the Manager derived an improper personal benefit…

Limitation of Duties; Conflict of Interest To the maximum extent permitted by applicable law, the Company and each Member, Manager, officer and employee of the Company hereby waives any claim or cause of action against any [Parent Company] Person for any breach of any fiduciary duty to the Company or its Members or any of the Company’s Affiliates by any such [Parent Company] Person, including, without limitation, as may result from a conflict of interest between the Company or its Members or any of the Company’s Affiliates and such [Parent Company]Person or otherwise. Each Member acknowledges and agrees that in the event of any such conflict of interest, each such [Parent Company]Person may, in the absence of bad faith, act in the best interests of such [Parent Company]Person, including without limitation its Affiliates, employees, agents and representatives…[S]uch waiver shall not apply to the extent the act or omission was attributable to the Manager’s gross negligence or knowing violation of law as determined by a final judgment, order or decree of a court of competent jurisdiction… .

The similar provisions of the operating agreement for Services, LLC, Simplexity’s subsidiary, provided (Services Agreement):

Exculpation.

(a) No Fiduciary Duties. To fullest extent permitted by law:

(i) notwithstanding any duty otherwise existing at law or in equity, and notwithstanding any other provision of this Agreement, no Indemnified Party shall owe any duty (including fiduciary duties) to the Company, the Member or any other Person that is a party to or is otherwise bound by this Agreement, in connection with any act or failure to act, whether hereunder, thereunder or otherwise; provided, however, that this clause (i) shall not eliminate the implied contractual covenant of good faith and fair dealing, and

(ii) No Indemnified Party shall have any personal liability to the Company, the Member, or any other Person that is a party to or is otherwise bound by this Agreement for monetary damages in connection with any act or failure to act, or breach, whether under this Agreement, the Act or otherwise; provided, however, that this clause (ii) shall not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing.

(b) No Personal Lability. If any provision of [the above-cited sections] is held to be invalid, illegal or unenforceable, the duties and personal liability of any Indemnified Party to the Company, of the Member or any other Person that is a party to or is otherwise bound by this Agreement shall be eliminated to the greatest extent permitted under the Act.

The defendants argued that they had no liability for breaches as to Simplexity because most of the parties to the Services Agreement were also party to the Simplexity Agreements, and therefore, the broad language of the Services Agreement that any “Member or any other Person that is a party to or is otherwise bound by this Agreement” covered Simplexity’s managers in their management of Simplexity.  Thus, they argued that the broad exculpation provisions of the Services Agreement were applicable to the managers of Simplexity.

The court disagreed and concluded that the Simplexity Agreement controlled the question of liability for management of Simplexity. The plain language of the Simplexity Agreement did not contain a clear intention to exculpate members and managers from fiduciary duty liability (contrast the language in the Services Agreement).  In other words, the Simplexity Agreement did not mitigate fiduciary duties and associated liability to the fullest extent permissible under Delaware law.  Rather, it expressly preserved claims for the breach of the duty of loyalty, gross negligence, and knowing violations of law. Thus, the defendants owed fiduciary duties and therefore could be held liable for their breach.

The take away is clear: Delaware law permits a limited liability company’s top brass to be insulated from fiduciary duty liability, but any such protection requires “plain and unambiguous” language in the charter documents. In the absence of plain and unambiguous language, managers and controlling members owe fiduciary duties, and can be found liable if they breach those duties.  If you want exculpation, be explicit.

The Supreme Court has granted certiorari to decide the question of whether bankruptcy courts should apply state law or a federal rule of decision when determining whether to recharacterize a debt claim as a capital contribution.

Recharacterization presents a critical issue for lenders and investors in distressed companies. Under the bankruptcy priority scheme, secured creditors get top priority, while equity interests have the lowest priority and are often completely wiped out.  A federal rule of decision more often leads to recharacterization of debt to equity than application of underlying state law.

Most circuits follow the federal rule of decision and apply a variety of multi-factor tests when analyzing whether to recharacterize debt as equity pursuant to the equitable powers granted bankruptcy courts by section 105 of the Bankruptcy Code. The Third, Fourth, Sixth, Tenth and Eleventh Circuits hold this majority view, while only the Fifth and Ninth Circuits apply state law.

In the case at issue, PEM Entities v. Levin, the Fourth Circuit affirmed the lower courts’ use of a federal rule of decision in permitting an insider’s secured loan to be recharacterized as a capital contribution.  Had the courts instead applied North Carolina state law, the debt would not have been recharacterized as equity.

The United States Bankruptcy Court for the Eastern District of North Carolina did not consider the fixed maturity date, required payments, third-party nature of the loan and first-lien security given for the loan as controlling the analysis. Rather, the Court focused on the discounted price paid for the distressed loan, the lender’s failure to enforce the original loan terms prior to bankruptcy, the debtor’s poor financial position at the time of the loan purchase, the lender’s insider status, the fact that the insider made additional capital contributions to the debtor and the inability of the debtor to obtain outside financing at the time the insider purchased the loan.

We will be following the proceedings and blog the decision of the Supreme Court on this important issue.

UPDATE:  On August 10, 2017, SCOTUS dismissed the petition for writ of certiorari as “improvidently granted,” ensuring that this split in the circuits will continue for the foreseeable future.

It is very common for bankruptcy court orders to provide that the court retains jurisdiction to enforce such orders.  Similarly, chapter 11 confirmation orders routinely provide that the bankruptcy court retains jurisdiction over all orders previously entered in the case.  The enforceability of these “retention of jurisdiction” provisions, however, will not rest on the plain language in the order but on the bankruptcy court’s statutory jurisdiction.  Because no court can simply create its own jurisdiction, whether these provisions are enforceable hinges on whether the dispute in question “arises under”, “arises in” or “relates to” the bankruptcy case as set forth by statute at 28 U.S.C. §§ 1334 and 157.

Recently, the First Circuit opined that a dispute involving a provision in a chapter 11 sale order did not “arise in” the bankruptcy case merely because the sale was approved by the bankruptcy court and the sale order included a “retention of jurisdiction” provision.   Gupta v. Quincy Medical Center, 2017 WL 2389407, Case No. 15-1183 (1st Cir. June 2, 2017).  The First Circuit recognized that “retention of jurisdiction” provisions are not sufficient to establish “arising in” jurisdiction—instead the bankruptcy court must consider the nature of the proceeding to independently determine if the matter could arise only in the context of a bankruptcy case.

The facts underlying Gupta are relatively straightforward.  Quincy Medical Center (QMC) entered into an asset purchase agreement (APA) to sell substantially all of their assets to an entity created by Steward Health Care System (Steward).  The APA required Steward to offer new employment to all QMC employees that were employed immediately prior to the sale closing.  The APA also provided that if Steward terminated any employee after the sale closed, then Steward would be liable for severance pay.  Immediately after executing the APA, QMC filed for chapter 11 to consummate the sale and liquidate.    Both the sale order and the later order confirming the chapter 11 plan included provisions retaining the bankruptcy court’s jurisdiction to determine disputes arising under or relating to the APA.

Shortly after the sale closed, Steward terminated two senior executives.  When Steward failed to pay severance, the former executives sought enforcement of the APA in the bankruptcy court.  The bankruptcy court determined it had subject matter jurisdiction to hear the dispute pursuant to the retention of jurisdiction language in the sale order and found Steward liable for the severance pay.  On appeal, the district court reversed, finding that the bankruptcy court lacked subject matter jurisdiction over the dispute.  The district court reasoned that the breach of contract claim fell outside the bankruptcy court’s subject matter jurisdiction – a contract dispute between two non-debtor parties – which could not be established by mere provisions in orders.   The First Circuit affirmed.

The First Circuit explained that the “jurisdiction of the bankruptcy courts, like that of all other federal courts, is grounded in, and limited by, statute.”  The scope of bankruptcy court jurisdiction is found at 28 U.S.C. § 1334.  Bankruptcy courts, by reference from the district courts, have jurisdiction over “cases under title 11”, and “proceedings arising under title 11, or arising in or related to cases under title 11.”  The statute provides no clear definition of “arising under”, “arising in” or “related to” and the First Circuit “observed that the boundaries between these types of proceedings are not always easy to distinguish from each other.”

The former executives did not assert “arising under” or “related to” jurisdiction; rather, they only argued that their severance claims “arise in” the bankruptcy case “because the APA was approved by the bankruptcy court in the Sale Order pursuant to [the bankruptcy code], and . . . . [the sale order] may ‘only be issued by a bankruptcy court.’”  In essence, the former executives asserted a “but for” causation:  “but for Debtors’ Chapter 11 case and the Sale Order approving the sale of Debtors’ assets to Steward in the APA, their claims for severance pay would not exist.”

The First Circuit rejected the “but for” test, instead holding that to establish “arising in” jurisdiction, the relevant proceeding must have “no existence outside of the bankruptcy[;]” “‘arising in’ jurisdiction exists only if Appellants’ claims are the type of claims that can only exist in a bankruptcy case.”   Examples of “arising in” proceedings are typically administrative in nature – orders to turn over property, dischargeability of debts and assumption or rejection of contracts.  Because the former executives’ claims were in the nature of a state law breach of contract claim, the First Circuit determined that the claims did not “arise in” the bankruptcy case and, therefore, the bankruptcy court did not have subject matter jurisdiction to determine the dispute.

Going forward, parties seeking to have their issues heard by a bankruptcy court should note that “retention of jurisdiction” provisions are not determinative.  Bankruptcy courts must look beyond the “retention of jurisdiction” language and determine whether the proceeding meets the statutory test of “arising under”, “arising in” or “relating to” the bankruptcy case.

Earlier this month, the Supreme Court announced that it will review the scope of Bankruptcy Code section 546(e)’s safe harbor provision. Section 546(e) protects from avoidance those transfers that are made “by or to (or for the benefit of)” a financial institution, except where there is actual fraud.  The safe harbor is intended to ensure the stability of the securities market in the event of corporate restructurings.

Now the Supreme Court is poised to determine whether this safe harbor precludes avoidance of a transfer made by or to a financial institution, where the financial institution is merely a conduit with no beneficial interest in the property transferred.

In July 2016, the Seventh Circuit held that the safe harbor does not protect transfers that are “simply conducted through financial institutions (or other entities named in section 546(e)), where the entity is neither the debtor nor the transferee but only the conduit.” FTI Consulting v. Merit Management, 830 F.3d 690, 691(7th Cir. 2016).

In this case, Valley View Downs, LP acquired the shares of a competitor for approximately $55 million, in which Merit had a 30% ownership interest. Valley View’s business strategy failed, and it filed for bankruptcy protection.  Subsequently, the trustee sought to recover the $16.5 million paid to Merit for the purchase of the shares for the estate.  While neither Merit nor the debtor were qualifying financial entities subject to the safe harbor of 546(e), the payment passed through two banks prior to being transferred by the debtor to Merit.  The Seventh Circuit determined that the statutory language was vague, and that Congress intended to protect only qualifying financial entities from avoidance, but not to protect entities that are not qualifying financial entities simply because a transfer passed through a financial intermediary.

The Seventh Circuit joined the Eleventh Circuit in so holding, while the majority of circuits – the Second, Third, Sixth, Eighth and Tenth have held that the 546(e) safe harbor does shield transfers that pass through a financial institution as merely a conduit. The Supreme Court is now expected to resolve this circuit split.

In a similar dispute, involving the Tribune Company LBO and subsequent bankruptcy, the Supreme Court has not yet granted nor denied the petition for certiori. In that case, which Distressing Matters discussed here, the Second Circuit held that the safe harbor prevents creditors from recovering under state constructive fraud theories when shareholders receive distributions under securities contracts effectuated through financial institutions.  Although the Tribune noteholders sought Supreme Court review of the Second Circuit’s ruling in September 2016, it appears that the Court is holding off on review of that particular issue for now. Stay tuned!

As noted in a recent Distressing Matters post, the United States Supreme Court in In re Jevic Holding Corp. held that debtors cannot use structured dismissals to make payments to creditors in violation of ordinary bankruptcy distribution priority rules.  The Jevic dissent complained that the majority avoided the more general question presented—whether a bankruptcy settlement can violate the statutory priority scheme.  The bankruptcy court for the Eastern District of Tennessee has addressed that complaint, holding that priority-altering settlements must be “fair and equitable” and promote a significant Code-related objective.

In In re Fryar, the bankruptcy court reviewed a settlement involving the sale of the debtor’s equity interests in two private ventures.  The IRS had a lien on the debtor’s equity interests.  The settlement proposed using the sale proceeds to pay off a bank lien on certain real estate, rather than using the proceeds to satisfy the IRS.  In exchange for the sale proceeds, the bank would release its lien on the real estate and retain a subordinated deficiency claim.  The IRS would then receive a lien on the now unencumbered real estate.  The bank acknowledged that if the sale proceeds were distributed according to the statutory priorities and the bank merely foreclosed on the real estate, its recovery would be less than half of what it stood to receive under the settlement.

Three unsecured creditors and the United States Trustee objected to the settlement on the basis that it reordered distribution priorities for the benefit of the bank. The bankruptcy court agreed, noting that the settlement allowed the bank to jump “to the head of the line.”  Absent the settlement, the proceeds would have gone first to the IRS to satisfy its lien on the equity, then to the estate for distribution to priority unsecured creditors (e.g., other unpaid tax claims) and finally to general unsecured creditors on a pro rata basis.

The bankruptcy court cited dicta from Jevic while considering the merits of the proposed settlement:

We recognize that Iridium is not the only case in which a court has approved interim distributions that violate ordinary priority rules. But in such instances one can generally find significant Code-related objectives that the priority-violating distributions serve. . . .  In doing so, these courts have usually found that the distributions at issue would “enable a successful reorganization and make even the disfavored creditors better off.” [Citations omitted].

Applying such guidance, the bankruptcy court determined that the settlement was more of a preamble to a conversion or structured dismissal than an anticipated reorganization and that the debtor did not prove that the settlement promoted a significant Code-related objective. Accordingly, the bankruptcy court sustained the objections to the settlement.

The bankruptcy court’s holding essentially establishes a new requirement for acceptance of any priority-altering settlement—post-Jevic, debtors wishing to consummate such settlements must now prove not only that the settlements are “fair and equitable” but also that the settlements promote a significant Code-related objective.  It remains to be seen whether other courts will demand that debtors meet similar standards for priority-altering settlements.

In a recent American Law Journal article, “When Hiding Assets Doesn’t Work: How Mintz Levin Recovered $20M for Cheated Client,” Daniel Pascucci and Joe Dunn detail the extensive efforts used to hold a judgment creditor accountable — 10 years and $20 million later, the case exemplifies the old saying that you can run, but you can’t hide.

In 2015, Distressing Matters reported on the Third Circuit’s decision in In re Jevic Holding Corp., wherein that panel ruled that, in rare circumstances, bankruptcy courts may approve the distribution of settlement proceeds in a manner that violates the Bankruptcy Code’s statutory priority scheme. The Third Circuit’s opinion endorsed the Second Circuit’s “flexible approach” solution to that question and rejected the Fifth Circuit’s finding that settlements must be “fair and equitable,” and thus comply with the priority scheme, as “too rigid.” Last year, the Supreme Court agreed to hear the case and address the circuit split.

The Court reversed (6-2) the Third Circuit ruling and held that bankruptcy courts may not approve structured dismissals that provide for distributions that do not conform to the ordinary priority rules, even as a “rare case” exception.

To briefly revisit the facts, the debtor was a financially-troubled trucking company. A private equity firm acquired the company in a leveraged buy-out and refinanced the company’s debt. Shortly thereafter, the company defaulted on these obligations and filed a Chapter 11 bankruptcy petition.

The company terminated most of its employees, including its truck drivers, just one day before filing the petition, which gave rise to a multimillion dollar priority wage claim. Despite the truckers’ priority status, distributions to the company’s senior lenders would have drained the company’s limited coffers, leaving nothing for the truckers.

At the same time, the unsecured creditors’ committee pursued fraudulent transfer claims against the senior lenders. Eventually, the senior lenders and the committee entered into a settlement agreement that would shuffle a few million dollars to the general unsecured creditors, thus bypassing the truckers’ priority claims. The bankruptcy court approved the settlement over the truckers’ objection and the district court affirmed that decision.

In a “close call,” the Third Circuit upheld the lower courts’ decisions, but stressed that deviation from the statutory priority scheme should occur only in those rare circumstances when bankruptcy courts “have specific and credible grounds to justify deviation.” Much of the Third Circuit’s reasoning attached to the simple fact that – whether the settlement was allowed or disallowed – the truckers would, in the court’s estimation, walk away empty-handed.

The Supreme Court disagreed. As Justice Breyer explained for the majority, the bankruptcy court cannot disregard the statutory priority scheme, at least not in the context of a structured dismissal.

A distribution scheme ordered in connection with the dismissal of a Chapter 11 case cannot, without the consent of the affected parties, deviate from the basic rules that apply under the primary mechanisms the Code establishes for final distributions of estate value in business bankruptcies.”

In reaching its conclusion, the Court reinforced that the priority rules are “a basic underpinning of business bankruptcy law” and “fundamental.” Admittedly, the structured dismissal statute gives bankruptcy courts a limited authorization to alter the status quo ante “for cause.” The Court ruled that flexibility does not extend to non-consensual modifications of the priority rules. Indeed, the Court suggested, departures from the status quo should only be permitted insofar as they are designed to protect third parties who reasonably relied on any modifications made throughout the course of the bankruptcy proceedings.

A dissent (authored by Justice Thomas and joined by Justice Alito) did not take aim at the majority’s reasoning but, instead, took umbrage with a perceived bait-and-switch. In Justice Thomas’ view, the Court granting certiorari on a particular question – whether a bankruptcy court may authorize the distribution of settlement proceeds in a manner that violates the statutory priority scheme – but that the truckers argued and the majority answered the related but narrower question of whether a Chapter 11 case may be terminated by a structured dismissal that distributes estate property in violation of the priority scheme.

The dissent underscores an important take-away. The Court’s determination that bankruptcy courts may not depart from the statutory priority scheme, even in rare circumstances, applies only to cases concluding with a structured dismissal. The practice of a secured creditor bypassing an intervening class and “gifting” proceeds to a lower class of creditors in other situations (e.g. plan confirmations, liquidations) remains a fair and fertile battleground.