Third Circuit Holds Structured Dismissals May in “Rare” Cases Deviate from Bankruptcy Code’s Priority Scheme

By Peter D. DeChiara

pdechiara@cwsny.com

Posted July 2015

Traditionally, Chapter 11 reorganization cases have ended with either a confirmed plan of reorganization, a conversion to Chapter 7, or a “no strings attached” dismissal of the case that restores the pre-bankruptcy status quo.  It has become increasingly common, however, for Chapter 11 cases to end with a “structured dismissal,” where a bankruptcy court dismisses the case by approving the terms of a settlement agreement between certain parties.  Unions have on occasion supported structured dismissals, when the settlement provides a distribution to employees that exceeds what the employees would have recovered, in a Chapter 7 liquidation or otherwise, had the Bankruptcy Code’s priority scheme been applied to their claims.  In many liquidations, secured lenders and secured creditors have often recovered all remaining assets, leaving nothing for employees.

The growing use of structured dismissals has made it more important than ever to resolve whether they are permissible, and, if so, whether payments approved as part of the dismissal may deviate from the creditor priorities set forth in Section 507 of the Bankruptcy Code.  In a much anticipated decision, the Third Circuit recently held that structured dismissals are permitted when the bankruptcy court determines that traditional methods for exiting Chapter 11 are unavailable and, moreover, that the settlement may deviate from Code priorities in those “rare” cases where the bankruptcy court determines that the deviating settlement is the best way to serve the interests of the bankruptcy estate and its creditors.  See In re Jevic Holding Corp., Case No. 14-1465 (3d Cir. May 21, 2015).

In Jevic, a trucking company was acquired by a private equity firm in a leveraged buyout financed by a group of lenders.  In 2008, in deep debt and with its business struggling, the company filed for Chapter 11, ceased operating, and laid off its employees.  The shutdown triggered two lawsuits.  The company’s drivers brought a WARN Act suit, claiming that the company failed to provide them required advanced notice of the shutdown.  The drivers later estimated that their WARN suit gave them a priority wage claim against the estate in the amount of $8.3 million.  In addition, the unsecured creditors committee sued the lenders on behalf of the bankrupt company’s estate, claiming that the leveraged buyout had saddled the company with debts that it couldn’t service.  The bankruptcy court later found that the committee’s fraudulent conveyance suit stated certain viable claims.

By 2012, with the bankruptcy case still pending, the debtor’s only remaining assets were the creditors committee fraudulent conveyance suit and $1.7 million in cash that was subject to the private equity firm’s lien.  At that point, the committee, the debtor and the lenders reached a settlement agreement that provided for, among other things, dismissal of the Chapter 11 case and the committee’s fraudulent conveyance suit and distribution of the cash, first to tax and administrative creditors and then pro rata to general unsecured creditors.  The drivers received nothing under the settlement, even though their priority wage claim put them ahead of the general unsecured creditors under the priority scheme in Section 507 of the Bankruptcy Code.  Over the drivers’ objection, the bankruptcy court approved the settlement and dismissed the Chapter 11 case.  The district court affirmed.

On appeal to the Third Circuit, the drivers argued that the bankruptcy court lacked authority to approve a structured dismissal, at least to the extent that a settlement agreement incorporating such a dismissal deviates from the Code’s payment priorities.  In a 2-1 decision, the Third Circuit disagreed.  Writing for the majority, Judge Thomas Hardiman explained that the bankruptcy court had the discretion to approve a structured dismissal in an appropriate case, absent a showing that the dismissal has been contrived to evade the Code’s safeguards for plan confirmation or for conversion of the case to Chapter 7.  The court accepted the bankruptcy court’s conclusions that in this case there was no prospect of confirmation of a plan of reorganization and that a conversion to Chapter 7 would have resulted in the secured creditors taking all that remained in the estate.  Stressing the value of settlements to the bankruptcy process, Judge Hardiman also wrote that payments under a settlement approved as part of a structured dismissal may skip over an objecting creditor class in those “rare “ cases where there are “’specific and credible’” grounds for deviating from the priority scheme.   While the court found it “regrettable” that the drivers had been excluded from the settlement, it nonetheless found the settlement justified.  The settlement, the majority opinion reasoned, was the “least bad” alternative, since it was the only one that provided a recovery to at least some creditors other than the secured lenders.

In his dissent, Judge Anthony Scirica agreed that a settlement may under certain circumstances depart from the Code’s priorities but he disagreed that this was one of the “extraordinary” cases where such departure was warranted.  The dissent argued that deviation from the priority rules is justified only when the settlement maximizes the value of the estate and here, he asserted, the settlement only maximized the recovery of certain creditors.  Judge Scirica also warned that because, in his view, circumstances like those in Jevic were not unusual, approval of the settlement in Jevic would undermine the general prohibition against settlements that deviate from the Code’s priority scheme.  Recognizing that disapproval of the settlement would have led to conversion of the case to Chapter 7, with only the secured creditors recovering anything, Judge Scirica wrote that he would have required the bankruptcy court to determine the amount of the priority WARN claims and applied the proceeds to those claims before claims in a lower priority.

In holding that a settlement approved outside of a plan of reorganization may deviate from the Bankruptcy Code’s order of priorities, the Third Circuit parted ways with the Fifth Circuit and cited with approval the approach of the Second Circuit.  In In re AWECO, Inc., 725 F.2d 293, 298 (5th Cir. 1984), the Fifth Circuit held that a bankruptcy court abuses its discretion by approving a settlement that fails to provide more senior creditors full priority over more junior ones.  In In re Iridium Operating LLC, 478 F.3d 452, 464-65 (2d Cir. 2007), the Second Circuit rejected this per se approach, holding that while compliance with the priority scheme is the most important factor to consider, a settlement outside of a plan may deviate from the Bankruptcy Code’s priority rules when factors weigh “heavily” in favor of the settlement.  

Since Delaware (which is in the Third Circuit) attracts a disproportionate share of Chapter 11 filings, the Jevic decision means that many employers who file for reorganization may now have the flexibility, in an appropriate case, to use a “structured dismissal” to exit bankruptcy, at least in circumstances where they are not evading a confirmable plan or conversion, and may also be able to exit via a settlement outside of a plan that deviates from the Code’s priority scheme.  In the Jevic case, the settlement hurt the truck drivers who received nothing for their priority WARN claim.  But in other cases, employees with junior claims may benefit from a settlement if, had the Code’s priority scheme been applied, more senior creditors would have left them no recovery.