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 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.

In an earlier blog piece we reported on the Third Circuit’s 2015 decision in In re Jevic Holding Corp. where the Court approved a settlement, implemented through a structured dismissal, which allowed junior creditors to receive a distribution prior to senior creditors being paid in full.  The decision was appealed and the Supreme Court agreed to hear the case and decide whether structured dismissals are permissible in bankruptcy.  More to come…

By LEN WEISER-VARON and BILL KANNEL

A few thoughts on Tuesday’s oral arguments before the U.S. Supreme Court in the litigation over whether Puerto Rico’s Public Corporations Debt Enforcement and Recovery Act, an insolvency statute for certain of its government instrumentalities, is void, as the lower federal courts held, under Section 903 of the U.S. Bankruptcy Code:

Continue Reading You Can Lead a Horse to Water, But You Can’t Call it an Airplane: Supreme Court Oral Arguments Suggest Puerto Rico’s Recovery Act May Recover

By LEN WEISER-VARON, BILL KANNEL and ERIC BLYTHE

It is said that muddy water is best cleared by leaving it be.  The Supreme Court’s December 4 decision to review the legality of Puerto Rico’s local bankruptcy law, the Recovery Act, despite a well-reasoned First Circuit Court of Appeals opinion affirming the U.S. District Court in San Juan’s decision voiding the Recovery Act on the grounds that it conflicts with Section 903 of the U.S. Bankruptcy Code, suggests, at a minimum, that at least four of the Justices deemed the questions raised too interesting to let the First Circuit have the last word. This discretionary granting of Puerto Rico’s certiorari petition further muddies the already roiling Puerto Rican waters.

Continue Reading Que Certa, Certa: Supreme Court’s Review of Puerto Rico Recovery Act May Hinder Creditor Negotiations

The Supreme Court has spoken once again on the limited jurisdiction of the bankruptcy courts, adding to the understanding derived from previous cases. Wellness International Network, Ltd., et al. v. Sharif is the Supreme Court’s sixth significant case exploring bankruptcy court jurisdiction under the Bankruptcy Code. For a brief and simplified history of bankruptcy jurisdiction jurisprudence shaped by these prior decisions, please jump to our prior advisory on this issue here.

In its previous decision in Executive Benefits Insurance Agency v. Arkinson, the Supreme Court left open two major issues: first, whether a creditor could impliedly consent to bankruptcy court jurisdiction to enter a final order by participating in the case without objection; and second, whether consent (express or implied) to jurisdiction to enter final orders is even valid under the Constitution. On the second issue, 28 U.S.C. §157 specifically provides the opportunity for all parties to consent and for the bankruptcy court to finally decide the matter. As we saw in Stern, however, that language does not make such a grant of jurisdiction constitutional.

The Court in Wellness went a long way toward answering these two questions. Wellness determined that Article III of the Constitution is not violated when the parties knowingly and voluntarily consent to adjudication of “gap” claims under Stern. “Gap” claims are those claims that are designated by statute as “core” issues but that cannot be treated as “core” because of the constitutional limits of bankruptcy court jurisdiction. After Wellness, there every reason to think that parties can consent on non-core” and related to” matters as well. Continue Reading Did The Supreme Court Finally Explain Stern? Examining the Wellness of Bankruptcy Court Jurisdiction