It’s an all-too-familiar situation: a debtor files for chapter 11 bankruptcy and an asset sale takes place, but there is not enough money at the end of the day to fund a plan confirmation process, or adequately pay off all creditors who come first in line according to the bankruptcy code. That “line” is defined by the bankruptcy code in its “absolute priority rule,” which essentially states that administrative claims come first (primarily, fees and expenses related to the post-petition date operations of the debtor, and for its chapter 11 professionals), then pre-petition secured claims, then pre-petition unsecured claims that have a special priority status (like taxes and employee wages subject to limitations), and then all other unsecured claims. But can this order of priority simply be sidestepped when a court determines it is in the general best interests of the creditor body as a whole—and how can that possibly be fair to investors who purchase higher-priority claims with the expectation that the letter of the law protects them from such uncertainty?
A ruling this year in the Third Circuit, in the case of In re Jevic Holding Corp. 787 F.3d 173 (3d Cir. 2015), says yes, the absolute priority rule can be sidestepped. In that case, an entire body of WARN Act claimants with priority claims were forced to accept a deal that left them out in the cold with no recoveries at all, even though other priority claimants were paid and lower-level unsecured claimants received some funds. There was no voting, no confirmation hearing, no nothing—just an agreement by the select parties who benefitted from that agreement, and a bankruptcy judge’s rubber stamp. The WARN Act claimants appealed, essentially quoting the old de-tuned Beatles country classic “Don’t Pass Me By.” But Ringo’s pleas to don’t make me cry fell on deaf ears and the appeals court upheld the decision, affirming the deviation from the rule.
At the heart of the issue here is the relatively recent concept that has evolved considerably over the last 7 or 8 years known as the “structured dismissal.” Structured dismissals are not specifically addressed in the bankruptcy code. They are only indirectly referenced by the fact that the bankruptcy court retains jurisdiction to settle disputes and issue orders while a case is open before it, and it has the power to end a case by ordering its dismissal from the court. The only practical difference between dismissals in the “old days” compared to the modern “structured dismissal,” is that the former was usually an exception not specifically anticipated, whereas the latter is generally planned out with the input and (ideally) consent of multiple parties with substantial diverging interests in a case.
In Jevic, the appeals court addressed the issue of whether structured dismissals are, in fact, permissible under the bankruptcy code. Its reasoning follows these same two points mentioned above. It stated that structured dismissals are “simply dismissals that are preceded by other orders of the bankruptcy court . . . that remain in effect after dismissal.” It supported this by pointing out that 11 U.S.C. § 349 gives the court authority to issue binding, post-dismissal terms when sufficient cause exists. Indeed, all the provisions of § 349 merely set forth the operable conditions of the dismissal in the absence of a specific order, for cause, issued by the Court, thus leaving the door open for any needed deviations, presumably so long as they are not arbitrary.
The Court in Jevic also pointed out that there was no nefarious attempt here to use the settlement agreement to circumvent a plan of reorganization process or chapter 7 conversion. A solicitation process to both prepare a plan (generally a lengthy legal document) and gather votes from a creditor body to approve such a plan would have soaked up a considerable amount of the estate assets. Likewise, a conversion to chapter 7 would entail many of its own new costs, all to the detriment of the creditors as a whole.
Thus, the only question remaining before the Court was whether “specific and credible grounds to justify [the] deviation” from the absolute priority rule existed. The justification was rather compelling—the priority portion of the WARN Act claim was substantial (over $8 mm), and would have significantly reduced payments to other creditors. Indeed, per the Bankruptcy Court in the case, the secured creditors Sun and CIT would have been the only other parties paid in any scenario other than that of the approved structured dismissal.
However, there were some other odd circumstances at work here. First, any payment on the WARN Act claim would have funded further litigation against the debtor’s secured lender, Sun Capital Partners. Thus, Sun had zero interest in ever obtaining a reasonable settlement with those claimants. And why should the WARN Act claimants have been so willing to accept any low-ball, token offers that may have come its way? After all, their high standing in the priority scheme should have afforded them some significant leverage—they certainly did not act like a party who had to decide between accepting a small gift and being sent packing with zilch.
Considering this, it was not without some consolation to many observers that the Appeals Court decision came with a dissent penned by Judge Scirica. This dissent is being looked to by many as a signal that the matter is far from clear-cut when it comes to future disputes of a similar nature, especially if litigated outside of the Third Circuit. In the dissent, Judge Scirica points out that unlike Iridiuim, the settlement here did not increase the overall value of the estate, and thus it did not increase total available recoveries for the general creditor body. In other words, where is the so-called “special circumstance,” when truly any proposal that deviates from the absolute priority rule will produce the same basic result as provided in Jevic—an increase of recoveries to certain creditors at the expense of others, but no aggregate increase to creditors in general.
Furthermore, the general impasse of this case was significantly tied to Sun’s refusal to allow recoveries to a class of creditors who would undoubtedly use those funds to litigate against Sun. Thus, there were powerful self-serving interests here, not a clear justification for the deviation from the absolute priority rule. Indeed, Scirica noted, the Jevic deviation far exceeded the more minor deviation of Iridium, and should thus have required an even greater standard of justification. Thus, Scirica would have remanded, with instructions to distribute settlement proceeds according to the absolute priority scheme but otherwise leaving the terms of the dismissal intact.
Structured dismissals are no doubt here to say, and the circumstances that lead to them will continue to be the car crash in which you lost your hair. Decisions like the Jevic appeal have no doubt complicated the planning for such situations, especially for claim buyers who otherwise could have been fairly confident about the schemes for payment that would be followed in a chapter 11 case by priority category. Indeed, the specter of uncertainty will lead to more creditors and claim-buyers singing don’t make me blue and positioning themselves so they’re not later appealing to a court singing Don’t pass me by. Jevic, 787 F.3d at 181  In re Iridium Operating LLC, 478 F.3d 452, 466 (2d Cir.2007), case law on the issue quoted by the Jevic Court in its decision.
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