The Order of Claims in Bankruptcy: Absolute Priority Rule, Structured Dismissals, and More

Are the Rules Really “Absolute?”

At its core, corporate bankruptcy addresses the problem of the “inadequate pie.” While occasionally the debtor will be solvent, in most cases, the debtor will, for lack of a better term, be “bankrupt.” That is, it won’t have enough money or other assets to pay its creditors all they are owed.

The Bankruptcy Code includes a number of provisions designed to help the bankruptcy estate maximize its value so that the creditor body can recover as much as possible. For example, it allows the debtor to be reorganized in Chapter 11, rather than liquidated in Chapter 7, where the debtor is worth more reorganized than liquidated. It also provides an “automatic stay” against creditor collection efforts, so as to give the trustee or debtor-in-possession a breathing spell to marshal the debtor’s assets and organize the debtor’s affairs. Finally, it permits the trustee or debtor-in-possession to “reject” most burdensome executory contracts and unexpired leases.

But, even after the exercise of all these powers, most debtors remain insolvent. The Bankruptcy Code therefore also needs to establish rules for the distribution of the inadequate pie—how big a slice does each claimant receive, and in what order of priority does it receive that slice, before the pie disappears? The order of claims in bankruptcy is governed by what’s known as the absolute priority rule.

The Code’s Order of Priority

In general, the Code provides that secured creditors are entitled to receive the entire value of the collateral securing their claims up to the full amount they are owed. Unsecured creditors, then, get to look to any remaining assets of the estate. But not all unsecured creditors are treated the same. Rather, the Code grants priority in right of payment to some.

The order of claims in bankruptcy starts with creditors who provide services or goods after bankruptcy is filed. Post-petition administrative claims—that is, creditors whose claims arose after the debtor filed for bankruptcy, for the actual and necessary costs of preserving the estate—usually have first priority.¹ Other creditors whose claims Congress deemed especially “worthy” are then afforded different levels of priority. For example, certain employment-related claims for wages, benefits or the like, up to specified dollar limits, are entitled to payment before other unsecured claims are paid. Certain tax claims, though junior in the priority waterfall to the employment-related claims, are also entitled to priority over most other unsecured claims.

Once² all the “priority” claims have been paid, general unsecured creditors then share pro rata in whatever value remains. In what is often termed the “absolute rule of priority,” equity holders are left last in line. These priority rules apply both in a Chapter 7 liquidation, and under a plan of reorganization under Chapter 11.³

Several court decisions have examined whether, in a Chapter 11 case, parties can “work around” these rules of priority. This article discusses two such cases: a U.S. Supreme Court decision, and a later bankruptcy court ruling applying, and distinguishing, that Supreme Court decision.

The Supreme Court, Jevic and the Order of Claims in Bankruptcy

The Supreme Court decision—Czyzewiski v. Jevic Holding Corp., 137 S.Ct. 973 (2017)—concerned a so-called “structured dismissal.” A Chapter 11 case typically ends in one of three ways: a plan of reorganization is confirmed under Chapter 11, the case is converted to a liquidation under Chapter 7, or the bankruptcy case is dismissed.⁴ Most dismissals simply return the debtor and its creditors to their respective pre-bankruptcy positions and reinstate the claims and obligations of all parties under non-bankruptcy law. But in a “structured dismissal,” the parties’ rights outside of (and potentially in) bankruptcy may be altered notwithstanding the dismissal of the case.

In Jevic, for example, the debtor-in-possession sought an order of the bankruptcy court dismissing its Chapter 11 case and also approving a settlement of a fraudulent transfer suit brought on behalf of the estate that distributed proceeds to general unsecured creditors even though employment-related claims of higher priority remained unpaid. The effect of the structured dismissal would have been to alter the normal order of claims in bankruptcy—general unsecured claims would have been paid whereas priority employment-related claims would not have been. And, adding insult to injury, the priority creditors would have been denied their right outside bankruptcy to bring their own fraudulent transfer suit against the settling defendant, because the bankruptcy estate’s settlement of the estate’s claim would have given the defendant a release. It also would have foreclosed any further litigation by any creditors asserting fraudulent transfer liability.

The facts in Jevic explain why the debtor and the settling defendants tried this gambit. Before going into bankruptcy, the debtor had been the subject of a leveraged buyout, or “LBO,” that added considerable debt to its balance sheet—debt that it ultimately could not pay. After the debtor went into bankruptcy, the bankruptcy court authorized the official committee of unsecured creditors appointed in the bankruptcy case to act as the representative of the estate and bring a fraudulent transfer suit against the lenders that financed the LBO and the private equity firm that acquired the debtor. The defendants agreed to settle the dispute on terms that would have provided cash to the bankruptcy estate to distribute to creditors.

The private equity firm, however, wanted to make sure that none of that cash ended up in the pockets of certain priority creditors—former employees of the debtor who had been terminated without the advanced notice required under state and federal “WARN” (Worker Adjustment and Retraining Notification) Acts and therefore had claims for wages entitled to priority under the Bankruptcy Code. Those employees were separately suing the private equity firm, claiming that it had become their de-facto employer by acquiring the debtor and was accordingly liable for their unpaid wages. The private equity firm didn’t want its settlement of the estate’s fraudulent transfer claim to give the employees a “war chest” to fund their WARN Act litigation, and it therefore made it a condition to the settlement that the proceeds had to be distributed to other, non-priority creditors—not to those employees, even though the employees’ claims against the estate were entitled to priority and the other creditors’ claims were not.

Reversing the bankruptcy court and two appellate courts, the U.S. Supreme Court held that this scheme violated the Bankruptcy Code. Specifically, it ruled that, without the consent of the higher priority creditors, a bankruptcy court may not order a distribution of estate assets to lower priority claimants as part of a structured dismissal of a Chapter 11 case.

The Court cautioned that it was not prohibiting what have become common practices early in Chapter 11 cases designed to foster the debtor’s chances of successfully reorganizing. For example, it was not prohibiting orders that would allow the trustee or debtor at the outset of a case to pay some wage claims so as to foster employee morale, or the general unsecured claims of critical vendors, even though other higher priority claims had not yet been paid. Instead, it stressed that these interim-payment practices were designed to maximize the estate for the ultimate benefit of all creditors, unlike the proposed structured dismissal in Jevic, whose very purpose was to disfavor the employment-related claims of the WARN Act creditors and to ensure that those creditors were never paid despite their right to priority.

In 2017, a bankruptcy court considered whether Jevic prevented so-called “gifting”—the practice where, for one reason or another, one senior class of creditors of a Chapter 11 debtor permits a subset of junior claimants to obtain a distribution that otherwise would go to the senior creditors, thereby allowing the junior claimants to bypass senior or equal-ranking claimants.

Prior to Jevic, a number of courts had approved “gifting” where the senior class giving up value consisted of secured creditors who were transferring to a class of unsecured creditors what otherwise would have been a distribution from the secured creditors’ collateral. But at least some courts had disapproved ‘gifting” where the senior class giving up value consisted of unsecured or even secured creditors who were transferring value to equity holders while a dissenting class of unsecured creditors had not received payment in full.⁵

Nuverra Environmental Solutions

In re Nuverra Environmental Solutions involved the former situation:

Secured creditors had a valid, unavoidable lien on substantially all the assets of the debtor and were owed substantially more than the value of their collateral. Nevertheless, as part of a pre-arranged plan of reorganization, the secured creditors agreed to allow the claims of the debtor’s unsecured creditors to “ride through” bankruptcy—that is, those claims would not be discharged in bankruptcy and, instead, would be paid in full in the normal course. Meanwhile, other unsecured creditors of equal priority, consisting principally of unsecured bondholders, received a very modest distribution

The secured creditors made this “gift” to the trade creditors, because under the plan they were going to receive most of the stock in the post-bankruptcy debtor and wanted to maintain good relationships with the debtor’s trade vendors. And, treating the trade creditors as “unimpaired” in bankruptcy made the plan confirmation process substantially easier.

The bondholder class voted to reject the plan, and an unsecured bondholder objected to its confirmation, arguing that the plan “unfairly discriminated” against the bondholders by providing superior treatment to the trade creditors. In an unpublished oral ruling, the bankruptcy court approved the plan, holding that nothing in Jevic prevented this give-up in value by secured creditors from their own collateral, even though the result was that one group of unsecured creditors (the trade) received substantially better treatment than another group of ostensibly equal priority unsecured creditors (the bonds).⁶

Conclusion

While “gifting” by a secured creditor to a junior class from the secured creditor’s own collateral may remain permissible (at least in some circumstances), Jevic makes clear that a trustee or debtor-in-possession may not use a “structured dismissal” of a Chapter 11 case to make distributions from unencumbered assets to junior claimants in violation of the rules of priority. For now, the order of claims in bankruptcy remains a steadfast rule.

We think you’ll also like:

1. Which Creditors Get Paid First? The Liquidation Order of (Absolute) Priority
2. Steps a Supplier Can Take in the Face of a Potentially Bankrupt Retailer

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can watch at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Help, My Business is In Trouble!
2. Opportunity Amidst Crisis – Buying Distressed Assets, Claims, and Securities for Fun & Profit

This is an updated version of an article originally published on August 22, 2017 and was previously updated on October 2, 2020]

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1. 11 U.S.C. § 507(a)(2)
2. 11 U.S.C. § 507(a)(4), (5) & (8).
3. 11 U.S.C. §§ 726, 1129.
4. 11 U.S.C. §§ 1112, 1129.
5. Compare In re Genesis Health Ventures, Inc., 266 B.R. 591 (Bankr. D. Del. 2001) (approving Chapter 11 plan under which secured creditors made a purported “gift” to certain classes of general unsecured claims from the secured creditors’ collateral, even though other classes of unsecured claims received nothing) with In re Armstrong World Indus., Inc., 432 F.3d 507 (3d Cir. 2005) (disapproving Chapter 11 plan under which one class of unsecured creditors made a purported “gift” to equity holders of consideration, and another class of unsecured creditors was not paid in full), and In re DBSD North America, Inc., 634 F.3d 79 (2d Cir. 2011) (disapproving Chapter 11 plan under which secured creditors made a purported “gift” to equity holders of consideration, and a class of unsecured creditors was not paid in full).
6. In re Nuverra Environmental Solutions, Inc., Case No. 17-10949 (KJC) (Bankr. D. Del. July 24, 2017).