Creditors Cutting in Line: Bankruptcy Settlements at SCOTUS

A weekly news service that publishes case summaries of the most recent important bankruptcy-law decisions, tracks major commercial bankruptcies, and reports on developments in bankruptcy reform in...

By Daniel Gill

Nov. 30 — When parties to a bankruptcy case decide to settle, sometimes creditors who wouldn’t normally collect get to move ahead in line—contrary to rules laid out in the Bankruptcy Code. The U.S. Supreme Court will address the issue of “structured dismissals” in its first bankruptcy case of the term during arguments on Dec. 7 ( Czyzewski v. Jevic Holding Corp., U.S., No. 15-649 (cert. granted 6/28/16)).

“This case involves both an extremely important issue in the context of Chapter 11 cases and a circuit split,” Michelle Harner, professor of law at the University of Maryland, told Bloomberg BNA via e-mail on June 28 (when the court agreed to hear the appeal). “The primary question presented is whether court-approved settlements in bankruptcy must adhere to the chapter 5 priorities and the absolute priority rule,” she said.

Some legal experts have argued that the statutory priority scheme for paying creditors is an overarching, fundamental precept of bankruptcy law which requires the court to overturn the courts below.

On the other hand, some law professors caution that an order overruling the Third Circuit decision below could have dire “unintended consequences” on bankruptcy jurisprudence. They argue that a blanket, strict adherence to the statutory priorities might unduly hinder real estate debtors or individual debtors from reorganizing in Chapter 11 and submit that nothing in the Bankruptcy Code prohibits such structured dismissals under the right circumstances. The respondents also point at other instances in bankruptcy practice when property might be distributed other than pursuant to the priority scheme laid out in the subject statutes.

The United States, 35 states and the District of Columbia also filed briefs in favor of the petitioners’ request to find the priority-skipping structured dismissal to be improper under the Bankruptcy Code. These governments are concerned that their own priority claims (usually for taxes) might be passed over by similar structured settlements if the Third Circuit’s decision is allowed to stand.

In an unusual case of bedfellows, an association of financial lenders (the Loan Syndications and Trading Association, or LSTA) also joined with labor interests (the petitioner truck drivers) in a friend of the court brief arguing along with the petitioners.

“Over thirty states and the LSTA have filed briefs supporting the petition in this case, illustrating that the fallout of this case is not limited to employees,” Prof. Melissa B. Jacoby, University of North Carolina School of Law, told Bloomberg BNA in a Nov 29 e-mail. “In future cases, anyone with less leverage under the circumstances could end up being the party excluded from receiving any payout.”

But first—at least as argued by one side of the dispute—the court will have to determine if it has jurisdiction to consider the question of whether bankruptcy courts can approve “structured dismissals” that allow certain creditors to jump the repayment line. The respondents in the case have argued that the petitioners do not have standing because there is no case or controversy; they claim that the petitioners suffered no damages by the lower courts’ decisions to approve the settlement and the “structured dismissal” of the Chapter 11 bankruptcy case.

Truckers and Creditors Sue

The petitioners seeking review by the court are a class of truckers who were fired without warning by the debtor trucking company, Jevic Holding Corp. As former employees of the bankrupt company, those truckers would have been entitled to priority over certain other creditors in a Chapter 11 plan by the company or if the company were liquidated in a Chapter 7 case (of course, assuming there were assets to distribute in either scenario).

Meanwhile, the committee of unsecured creditors appointed in the Chapter 11 case sued Sun Capital Partners, who acquired Jevic Holdings in a leveraged buyout (LBO) in 2006, and CIT Group, the debtor’s major secured lender, on a fraudulent transfer claim or claims.

The creditors committee, the debtor, Sun and Citi ultimately entered into a settlement which provided for a release of Sun and Citi and for those companies to pay $3.7 million. The agreement also provided for which creditors would be paid from those funds, and that list explicitly excluded the truckers, who objected to the settlement.

Sun and/or Citi told the bankruptcy court that it would not have agreed to settle if the truckers were to receive anything from the settlement funds.

Under the court-approved settlement agreement, the bankruptcy case would be dismissed; certain priority creditors would be paid; and the general unsecured creditors would share a distribution from a pool. But the truckers—whose claims would have had priority over the general unsecured creditors in a Chapter 11 plan or Chapter 7 distribution—were left entirely out of the money.

Priority and Flexibility

The “absolute priority rule” is codified at Bankruptcy Code Section 1129(b)(2)(C)(ii) and provides that a Chapter 11 plan can’t be confirmed over objection if a claimant with junior priority is paid before senior priority claims are satisfied.

Section 507 of the Code provides the priority by which certain creditors are to be paid in a distribution made in bankruptcy.

One side of the dispute wants the Supreme Court to determine that the priority distribution scheme set forth in 11 U.S.C. §507 and the absolute priority rule of §1129 are overarching principals of bankruptcy providence which cannot be subverted in any context.

The other side would have the court affirm the Third Circuit and find that courts have some leeway—that the absolute priority rule necessarily applies only in a Chapter 11 plan and that the Section 507 priorities are required only in such plans or in a Chapter 7 distribution.

David Kuney, a Washington attorney and adjunct professor at Gerogetown law, authored one of the amicus briefs in favor of the respondents. He told Bloomberg BNA Nov. 17 that the absolute priority rule is not an overarching principle of bankruptcy and that the strict reading sought by the petitioners could have dire unintended consequences in bankruptcy jurisprudence.

Single asset real estate cases are a prime example, he said. “In a real estate case, the owners always need to retain some ownership interest in the property” by the time a plan is consummated or the case otherwise closed. A strict, unbending application of the absolute priority rule—and its important corollary, the new value exception—could eliminate bankruptcy relief for such cases, he said.

The new value exception allows debtors to maintain equity—even if creditors higher on the payment totem pole aren’t paid in full—by contributing new capital or other value to the reorganizing debtor as part of the plan of reorganization. Kuney suggested that a Supreme Court decision in favor of the petitioners could put that model at risk.

Kuney also suggested that an inflexible approach to priority schemes could also kill individual debtors’ chances of getting relief in Chapter 11 (i.e., if the plan doesn’t provide for payment of all creditors in full).

Case or Controversy?

Apparently for the first time in this litigation, the respondents argue in their Supreme Court brief that the court is without jurisdiction to decide the case because there is no real case or controversy that can be resolved by a judicial determination. This argument—also posited in one of the amicus briefs filed by a group of law professors—suggests that if the structured settlement were not allowed, the priority claimant truck drivers would receive nothing (i.e., if the case were simply dismissed or if it were converted to Chapter 7), because Citi’s senior lien claim would consume all assets of the estate, with nothing for any of the creditors.

One of the law professors submitting a brief in support of the truckers’ position found the respondents’ jurisdiction argument surprising. “It’s curious that respondents apparently now argue that the bankruptcy court didn’t have the power to grant the approval of the settlement that they earlier sought from the bankruptcy court and now seek to defend,” Jonathan Lipson of Temple University–Beasley School of Law, Philadelphia, told Bloomberg BNA Nov. 17.

The truckers dispute the jurisdiction argument and say that while the bankruptcy court predicted that there would be no recovery available to the truckers if the case were dismissed or converted, the court never made such a finding of fact. They argue that as creditors they (or a Chapter 7 trustee representing their interests if the case went into Chapter 7) would at the very least be able to assert the fraudulent transfer claims against Sun and Citi, and that the settlement deprived them of a right to bring that cause of action (because the defendants were released).

The truckers note in their reply brief that because a reversal of the lower courts would revest the right to assert the claims against Sun and Citi, the truckers suffered an “actual injury” that is “likely to be redressed by a favorable judicial decision.”

They say that the lower courts’ conclusions that a recovery was unlikely was not dispositive and that they would at least be entitled to seek relief against those defendants.

Effect of Decision

Assuming that the high court determines that some form of relief is available to the petitioners and therefore that the court has subject matter jurisdiction to decide the case, its ruling could have significant consequences on the shape of bankruptcy law to come.

Or it might not. Prof. Lipson told Bloomberg BNA Nov. 17 that an order reversing the Third Circuit doesn’t have to sound a death knell for structured settlements as a means for parties to exit Chapter 11. That avenue would still be available absent an objection from a party in interest, he said.

Others—those aligned with the respondents—fear that a Supreme Court decision establishing the absolute priority scheme as an overarching principle of bankruptcy law could have dire unintended consequences, including for Chapter 11 cases contemplated by real estate companies or individual debtors whose debts are too great to qualify for Chapter 13, and for whom Chapter 7 is a poor alternative.

To contact the reporter on this story: Daniel Gill in Washington at dgill@bna.com

To contact the editor responsible for this story: Jay Horowitz at JHorowitz@bna.com

Copyright © 2016 The Bureau of National Affairs, Inc. All Rights Reserved.