The U.S. bankruptcy world has been abuzz since the influential Third Circuit approved a “structured dismissal” in which senior creditors seemingly colluded with junior creditors to circumvent the rights of certain middle-priority claimants. Observers of this discussion of Jevic Holding’s Chapter 11 case should beware, however. This is little more than the next in a long line of predictable cases that pits pure principle against expedient practicality in the no-win situation of total insolvency. The case is noteworthy, but its scope of application is rather narrower than many headlines would lead one to believe.
The basic controversy in Jevic concerns the rigid (or flexible) application of the principle of so-called absolute priority. Creditors with higher priority claims are forced to accept a loss in bankruptcy, the principle holds, only so long as creditors (or equity holders) with lower priority claims receive nothing. In a system like that in the U.S., where restructuring outcomes are largely controlled by debtor-companies, the fear is omnipresent that insiders like old equity will use this power to extract value from a reorganization effort at the expense of unpaid creditors. The absolute priority rule is designed primarily to prevent this self-dealing by old equity.
But the rule also restricts the ability of lower-ranking creditors, such as general unsecured claims, from receiving payment until higher ranked creditors, such as priority unsecured claims, are paid in full. It is widely accepted that a plan of reorganization is bound by this absolute priority rule. The novelty in Jevic is a long-awaited resolution of whether settlement agreements are subject to the same rule. By confirming that the answer is “not always,” the Third Circuit’s ruling has given rise to fears of schemes by companies and their high-ranking creditors to distribute assets as they wish, subverting the rules of priority, by using settlement agreements and dismissals instead of confirmed plans of reorganization (or liquidation).
Thus, in Jevic, a group of recently fired employees asserted that the company had violated the absolute priority rule in a “structured dismissal” of its bankruptcy case. An agreement preceding the dismissal improperly diverted settlement money to lower-priority general claimants, the employees argued, rather than to the employees on their priority wage claims.
Note immediately that the employees did not claim actual loss–the debtor-company had no assets that would have been distributed to the employees even in a liquidation. Jevic had collapsed under the weight of secured debt following a leveraged buyout. All of its assets were encumbered with first-priority liens in favor of the LBO participants. The only reason any value was distributed to any unsecured creditor was that the LBO participants had agreed to fund payments to these low-ranking creditors to settle a fraudulent conveyance lawsuit claiming the LBO participants had denuding the company of value and caused its bankruptcy.
It is not entirely clear why the LBO participants agreed to pay anything to settle this lawsuit. While the court had refused to dismiss the case against the LBO participants, the case remained quite weak, and the company lacked financing to pursue the lawsuit any further.
Nevertheless, in exchange for an immediate release of potential liability, the LBO participants agreed to reimburse the company’s lawyers’ fees and litigation costs and to release their liens on the company’s last remaining assets, $1.7 million in cash. This cash would be deposited into a trust, from which pro-rata distributions would be made, in part, to general unsecured claimants. The former employees were shut out of this settlement, yet they claimed they were owed some $8 million in priority wage claims, higher in the priority scheme than general unsecured creditors who would receive payment from the settlement trust.
The bankruptcy court had to approve this settlement as “fair and equitable,” and the employees predictably argued that a settlement scheme that skipped over their higher-priority claims and violated the absolute priority rule could not be deemed fair. Three relatively rare factors supported the court’s conclusion to approve the settlement as the “least bad alternative”: First and foremost, the debtor-company had no hope of continuing with its bankruptcy case, as it lacked any unencumbered assets to fund a confirmed plan of reorganization or even to administer a liquidation. Second, and closely related, with no assets available to any but secured creditors, the employees’ priority unsecured claims were “effectively worthless,” so they would suffer no practical loss as a result of the priority-skipping concession of this value from secured creditors to general unsecured creditors.
Third, though the fraudulent conveyance case against the LBO participants might have produced some value if it were successful, the company lacked funding for continued litigation. The LBO participants, in contrast, had ample resources to fund a vigorous defense.
U.S. law would allow an enterprising lawyer to take the case on a contingency basis (with the lawyer recouping a percentage of any recovery, but losing all fees and expenses if the case failed), but the court concluded that the case was “uncertain at best” on the merits, so only a lawyer who “should have his head examined” would agree to accept such a risk.
The Third Circuit resolved an important “principle of the matter” dispute in Jevic by holding that absolute priority does not always prohibit structured dismissals. But the court did not simply cast aside the rule in favor of expediency. The Third Circuit refused to allow unbending principle to override compelling practicality, but it simply read some flexibility into the rule, and only in light of the extreme circumstances of what the court emphasized was a “rare case.”
It is clear that such a priority-skipping scheme would be flatly prohibited in a plan of reorganization. It is also fairly clear that even an agreement of settlement-and-dismissal would be rejected as not “fair and equitable” if the debtor had access to any unencumbered asset value sufficient to finance a liquidation and ordinary distribution (even if only to secured creditors). Nor would such a settlement likely be approved if the case to be settled had stronger merits, providing access to possible contingency-fee litigation financing. Structured dismissals are likely to remain an acceptable solution only in the type of extreme confluence of circumstances presented in Jevic.