Yesterday, the Supreme Court granted certiorari in Czyzewski v. Jevic Holding Corp (“Jevic”). As previously reported, Jevic addressed whether a bankruptcy court can approve a settlement agreement that provides for distributions that violate the absolute priority rules as part of the structured dismissal of a chapter 11 proceeding. The Third Circuit held that such structured dismissals were appropriate even when they provided for distributions that do not strictly comply with the Bankruptcy Code’s absolute priority schemes.  The Third Circuit’s ruling is consistent with the Second Circuit’s holding in In re Iridium Operating LLC,[1] which held that such structured dismissals may be appropriate if they are justified by other factors, but put the Third Circuit in conflict with the Fifth Circuit, which held in Matter of AWECO, Inc.[2] that it was inappropriate to approve a structured dismissal that did not strictly comply with the absolute priority rule. The Supreme Court will now address this circuit split and decide whether the flexibility offered to debtors (and some creditors) by structured dismissals outweighs that impact that such dismissals can have on the rights of other creditors and interested parties as discussed in our prior post. The Supreme Court’s decision may also have a broader impact on non-priority distributions more generally and could affect the permissibility of “gift plans,” which are similar to the structured dismissals in Jevic as they often provide for secured or senior creditors to make payments to junior creditors in order to garner support for chapter 11 plans.  Check back with the HHR Bankruptcy Report as we continue to cover the briefing, developments, and potential impact of Jevic.

[1]               478 F.3d 452 (2d Cir. 2007)

[2]               725 F.2d 293 (1984).

Last summer, the HHR Bankruptcy Report analyzed the Third Circuit’s ruling in Official Committee of Unsecured Creditors v. CIT Group/Business Credit Inc. (In re Jevic Holding Corp.),[1] which approved, as part of the structured dismissal of a chapter 11 proceeding, a settlement agreement that allowed distributions that violated the absolute priority rule.  Following the Third Circuit’s ruling, the aggrieved priority creditors filed a writ of certiorari in the hope that the Supreme Court would address the split between the Courts of Appeals as to whether settlements must follow the absolute priority rule.[2] Now, in response to an invitation from the Supreme Court, the Solicitor General has submitted an amicus brief on behalf of the United States encouraging the Court to grant certiorari and to overturn the Third Circuit’s ruling.

The United State government has a particular and somewhat unique interest in having the Supreme Court review the Third Circuit’s decision. Federal taxing authorities (e.g. the IRS) are granted either second priority or eighth priority claims by the Bankruptcy Code depending on whether the tax obligation arose pre or post-petition. Accordingly, the government recognizes a real danger that, as a result of the Third Circuit’s ruling, debtors could collude with junior creditors to “squeeze out” government tax claims with a higher priority.

At issue in Jevic was the approval of a settlement agreement between the debtor, the Unsecured Creditors’ Committee and defendants to fraudulent transfer actions, that provided, in part, for (i) distributions to certain administrative and unsecured creditors as part of a structured dismissal of the chapter 11 proceeding, but did not provide for (ii) distributions to the debtor’s former employees who held higher priority claims arising from WARN Act liability. The former employees objected to the approval of the settlement on the ground that a bankruptcy court cannot approve a settlement and related structured dismissal of the case that does not comply with the order of priorities set out in section 507 of the Bankruptcy Code. Relying on the fact that it was highly unlikely that the debtor would confirm a plan of reorganization or that the employees would receive any distribution in a chapter 7 liquidation, the Third Circuit rejected the employees’ argument and held that a chapter 11 proceeding may be resolved, in rare circumstances such as those presented in the Jevic proceeding, through a structured dismissal that deviates from the Bankruptcy Code’s priority scheme.

The Solicitor General argued in his amicus brief that the Third Circuit had erred in reaching its holding for a number of reasons. First, the order of priorities established by the bankruptcy code reflects Congress’s detailed balancing of the rights and expectations of various creditor groups, and that by approving a settlement that deviated from this order of priorities, the bankruptcy court was upending “that carefully balanced system.” The Solicitor General noted that this outcome was particularly incongruous when compared to the requirements for chapter 11 plan confirmations and chapter 7 liquidations where priority creditors must be paid first (unless they consent to impairment). Second, the Solicitor General disagreed with the Third Circuit’s reasoning that a deviation from the Bankruptcy Code’s priority scheme was justified by the fact that the employees would not be prejudiced by the settlement because there was no prospect of a chapter 11 plan being confirmed or of a distribution to priority creditors if the case was converted to a chapter 7 liquidation (i.e. the employee creditors would be in the same position whether or not the settlement was approved). The Solicitor General noted that if the case had “simply been dismissed” pursuant to section 1112 of the Code, the employees could have pursued a fraudulent –conveyance action against the settling defendants on a derivative basis as creditors of Jevic. So rather than being outcome neutral, the employee creditors were being directly deprived of a potential source of recovery.  The Solicitor General also argued that granting certiorari was appropriate in this case because of the existing split between the Circuitx on this issue, as well as the real and significant impact the ruling could have on the rights of creditors in future proceedings.

The Solicitor General’s amicus brief highlights the potentially wide impact of the Third Circuit’s ruling, despite the court’s attempt to limit its holding to cases where “specific and equitable grounds” justify deviation from the priority scheme. It is conceivable that in nearly every case where a debtor is administratively insolvent, a justification could be found for deviating from the absolute priority rule under the Third Circuit’s ruling.  In those circumstances, debtors will be able to apply strong bargaining pressure on priority creditors to accept reduced claim amounts, less the debtor strike a settlement with other junior creditors of the case that cuts out the recalcitrant priority creditor entirely.  Additionally, in light of the Circuit split on the issue, the Third Circuit’s ruling raises forum shopping concerns, as debtors (many of whom are organized under the laws of Delaware) will be more likely to commence proceedings in the Delaware bankruptcy court, if only to ensure themselves the benefit of the debtor-friendly rule adopted by the Third Circuit.

Check back with us in the future as we will to continue to cover developments in Jevic.

[1]         787 F.3d 173 (3rd Cir. .2015).

[2]         Compare In re AWECO, Inc 725 F.2d 293 (5th Cir 1984)(finding that a bankruptcy court abuses its discretion in approving a settlement agreement that does not comply with the absolute priority rule); with In re Irdium Operating LlC, 478 F.3d 452 (2d Cir. 2007) (holding that a settlement may deviate from the absolute priority rule in certain circumstances).

The Third Circuit’s decision in In re Trump Entertainment presents interesting opportunities for employers with expired collective bargaining agreements (“CBAs”) seeking to reorganize their companies under Chapter 11 of the Bankruptcy Code. [1] In In re Trump Entertainment, the Court held that a debtor may reject an expired CBA under Section 1113 of the Bankruptcy Code despite the specific limitations on such rejections contained in the National Labor Relations Act (“NLRA”). The Third Circuit’s ruling may provide extra bargaining power and flexibility to companies whose reorganization efforts are impacted by CBAs and labor disputes.

In Trump Entertainment, the debtors were the owners and operators of the Trump Taj Mahal Casino. In 2011, they had entered into a CBA that required the debtors to contribute $3.5 million per year to its pension and an additional $10-12 million per year for healthcare and welfare expenses.  A few months prior to expiration of the CBA, the debtor and its union engaged in good faith negotiations to amend and extend the CBA. However, these negotiations ultimately proved unsuccessful and by September 2014, the debtor had $286 million in secured debt and only $12 million in working capital.  As a result, the debtor filed for Chapter 11 bankruptcy and as soon as the CBA expired moved to reject the CBA under Section 1113 of the Bankruptcy Code. The Bankruptcy Court granted the debtor’s motion effectively rendering the expired CBA unenforceable and freeing the debtor from the pension and healthcare funding obligations.  The union promptly filed a direct appeal to the Third Circuit.

This case presented a matter of first-impression as it involved a conflict between two federal statutes; Section 1113 of the Bankruptcy code, and the NLRA. The NLRA states that an employer cannot unilaterally change the terms of a CBA even after it expires.[2] In contrast, Section 1113 of the Bankruptcy Code allows a debtor to reject its CBA if: (i) the debtor proposed modifications to its CBA that would allow the company to successfully reorganize; (ii) the employees’ authorized representative rejected the employer’s proposals; and (iii) the bankruptcy court determined that the “balance of equities clearly favors” rejecting the CBA.[3] The debtor argued that there should be no distinction between unexpired CBAs and expired CBAs under Section 1113 of the Bankruptcy Code and therefore it was entitled to reject the contract as it had satisfied the other requirements of Section 1113. In contrast, the union argued that an expired CBA could not constitute a “contract” which could be rejected under the terms of Section 1113 of the Bankruptcy Code.

The Court broadly reviewed the legislative purpose behind both statutes before holding that there should be no distinction between expired and unexpired CBAs under Section 1113 of the Bankruptcy Code. In further support for its holding, the Third Circuit noted that this was consistent “with the purpose of the Bankruptcy Code which gives debtors latitude to restructure their affairs.”[4] The Court expanded on this holding by noting that it is preferable for a company to reject its CBA for the sake of preserving jobs than adhering to the stringent terms of its CBA which results in the permanent loss of jobs.[5]

The Third Circuit’s decision may help strengthen reorganizing corporations bargaining position as it expands their ability to shed continuing obligations under an expired CBA. Although this comes at the expense of unions’ potential negotiating positions, a potential debtor’s power is still tempered by the fact that the potential debtor must comply with the strict procedural requirements of Section 1113 of the Bankruptcy Code.

[1] 810 F.3d 161 (2016).

[2] 29 U.S.C. 158(a)(5)

[3] 11 U.S.C. § 1113

[4] Id. at 173.

[5] Id. at 174.

The Third Circuit has affirmed the Delaware Bankruptcy Court’s approval of a section 363 sale and related settlement agreement over IRS’s objection to provisions in the sale and settlement agreements that provide payments to unsecured creditors and other administrative creditors while leaving the IRS with no recovery. While the IRS argued that the sale and settlement violated the absolute priority rule by favoring creditors with an equal or lesser priority under the Bankruptcy Code’s distribution scheme, the Third Circuit found that neither the funds set aside to make payments to unsecured creditors nor the funds set aside to pay other administrative creditors constitutes property of the debtor’s estate. As the Bankruptcy Code’s creditor-payment hierarchy is applicable only to property of the debtor, therefore, it was not implicated by the provisions in the sale and settlement agreements.

Prior to the petition date, and after failing to attract purchase offers that exceeded its debt obligations, LifeCare Holdings, Inc. entered into an asset purchase agreement with an acquisition vehicle made up of its secured lenders—who were undersecured due to the falling value of the company—whereby the secured lenders credited $320 million of the $355 million debt they were then owed in return for the cash and assets of LifeCare. In addition, the lenders agreed to pay the legal and accounting fees of LifeCare and the Committee of Unsecured Creditors, as well as the company’s wind-down costs, and to deposit funds into separate escrow accounts for the purpose of paying those amounts. The day after entering into the asset purchase agreement, LifeCare and its subsidiaries filed for bankruptcy and asked for permission to sell substantially all of its assets through a section 363 auction. Ultimately, the secured creditors’ “credit bid” remained the most attractive offer. After an objection to the sale by the Committee, the secured lenders’ group entered into a settlement agreement with the Committee whereby the secured lenders agreed to deposit $3.5 million in trust for the benefit of the general unsecured creditors.

The US Government, representing the IRS, objected to the sale and the settlement and sought a stay on the distribution of funds to creditors, arguing that the sale would result in a large capital-gains tax liability, thereby giving them an administrative claim, and that the proposed sale and settlement agreements therefore violated the absolute priority rule by providing for payments to be made to equally situated administrative creditors—primarily bankruptcy professionals—and to unsecured creditors.

In determining that the sale and settlement were properly approved by the Bankruptcy Court, the Third Circuit described the central issue as “whether certain payments by a section 363 purchaser . . . in connection with acquiring the debtors’ assets should be distributed according to the Code’s creditor-payment hierarchy.” The court focused on its view of the substance of the sale over form and found that the money in question was not paid at the debtors’ direction, consisted of the purchaser’s own funds, and never entered the estate.

The Third Circuit’s ruling may provide incentive for undersecured lenders to make similar credit bids, and for debtors to accept such bids. While potential purchasers, debtors, and creditors may be tempted to use the decision as a map to altering the Bankruptcy Code’s distribution scheme and a avoiding the tax implications of section 363 sales, the adoption of this approach by other circuits is not certain. For now, creditors should be warned that they risk being bypassed by such sale arrangements.

The Third Circuit, in Official Committee of Unsecured Creditors v. CIT Group/Business Credit Inc. (In re Jevic Holding Corp.),[1] became the first court of appeals to approve the settlement and dismissal of a chapter 11 case. Structured dismissals, as understood by the Third Circuit, are “simply dismissals that are preceded by other orders of the bankruptcy court (e.g., orders approving settlements, granting releases, and so forth).” This decision may provide flexibility in future bankruptcy resolutions as structured dismissals may become a tool for parties and judges, and deviation from the Bankruptcy Code’s claim priority scheme can be permitted in rare situations.

In 2006 Jevic Transportation, Inc. (“Jevic”), a New Jersey trucking company, was acquired by a subsidiary of Sun Capital Partners (“Sun”) in a leveraged buyout led by CIT Group (“CIT”). Two years later, Jevic filed a voluntary chapter 11 petition in the United States Bankruptcy Court for the District of Delaware. During the bankruptcy proceedings, two lawsuits were filed against the debtor: (i) a group of Jevic’s terminated truck drivers (“Drivers”) filed a class action against Jevic and Sun alleging violations of federal and state Worker Adjustment and Retraining Notification Acts because the Drivers were not given 60 days written notice before termination;[2] and (ii) the Official Committee of Unsecured Creditors (“Committee”) brought a fraudulent conveyance action against CIT and Sun on the estate’s behalf.[3] In March 2012, three of the parties – the Committee, CIT and Sun – reached a settlement agreement, under which the the fraudulent conveyance and preference actions would be dismissed, CIT would contribute $2 million to pay legal fees and administrative expenses for Jevic and the Committee, Sun would transfer its lien on Jevic’s assets to a trust in order to fully pay administrative and tax creditors (but not other priority creditors) and to pay unsecured creditor on a pro rata basis, and finally the bankruptcy case would be dismissed. The settlement did not include the Drivers who, along with the U.S. Trustee, objected to the settlement on the grounds that structured dismissals were not authorized under the Bankruptcy Code and that the settlement violated the Bankruptcy Code’s priority scheme by excluding the Drivers priority wage claims.

The Third Circuit had to determine whether structured dismissals were allowed under the Bankruptcy Code and if so, whether strict compliance with the Code’s priority distribution scheme in § 507 was required. The majority found that “absent a showing that a structured dismissal has been contrived to evade the procedural protections and safeguards of the [chapter 11] plan confirmation or conversion processes, a bankruptcy court has discretion to order such disposition.” The Third Circuit then compared the outcome of cases in the Fifth and Second Circuits that discussed whether the priority scheme must be followed when settlement proceeds are distributed in chapter 11 cases, and found that in “rare” circumstances a structured dismissal that does not strictly adhere to the Code’s priority scheme is warranted. The Fifth Circuit, in Matter of AWECO, Inc., held that the “fair and equitable” standard required by Federal Rule of Bankruptcy Procedure 9019 applies to settlements and that “fair and equitable” means compliant with the priority system.[4] In In re Iridium Operating LLC the Second Circuit held that a settlement that did not comply with the priority scheme could be approved as long as the balance of other factors weighed heavily in favor of approving a settlement and that “specific and credible grounds to justify [the] deviation” existed.[5] The Third Circuit followed the more flexible Iridium approach. Admittedly unsatisfied by the exclusion of the Drivers, the Third Circuit conceded that, when compared with “no prospect” of a plan being confirmed or the secured creditors’ taking “all that remained” in a chapter 7 conversion, the settlement was the “least bad alternative.” The dissent did not find the special circumstances required by Iridium present in Jevic.

This decision is the first by a circuit court of appeals to approve the use of a structured dismissal as an alternative to converting a case to chapter 7 or returning the parties to status quo via dismissal. Future use of structured dismissals will help clarify and continue to refine the definition of “rare” circumstances. For now, debtors should note the possibility of utilizing a structured dismissal and secured creditors should be warned that they may now risk being frozen out of settlements to the benefit of unsecured creditors.

[1].      No. 14-1465 (3d Cir. May 21, 2015).

[2].      The Bankruptcy Court eventually granted summary judgment for Sun finding that it did not qualify as an employer of the Drivers, In re Jevic Holding Corp., 492 B.R. 416, 425 (Bankr. D. Del. 2013), and entered summary judgment against Jevic because it had violated the New Jersey Worker Adjustment and Retraining Notification Act, In re Jevic Corp., 496 B.R. 151, 165 (Bankr. D. Del. 2013).

[3].      CIT’s motion to dismiss was granted in part and denied in part. The Bankruptcy Court held that the Committee had adequately pleaded claims of fraudulent transfer and preferential transfer under 11 U.S.C. §§ 548 and 547, but dismissed without prejudice the Committee’s claims for fraudulent transfer under 11 U.S.C. § 544. In re Jevic Holding Corp., 2011 WL 4345204, at *10 (Bankr. D. Del. Sept. 15, 2011).

[4].      725 F.2d 293, 298 (1984).

[5]       In re Iridium Operating LLC, 478 F.3d 452, 464, 466 (2d Cir. 2007). The four factors, from In re Martin are (1) the probability of success in litigation; (2) the likely difficulties in collection; (3) the complexity of the litigation involved, and the expense, inconvenience and delay of necessarily attending it; and (4) the paramount interest of the creditors. 91 F.3d 389, 393 (3d. Cir. 1996).

Continuing a string of decisions interpreting tax-sharing arrangements, the Third Circuit recently held that under California law, a tax-sharing arrangement unambiguously created a debtor-creditor relationship and did not create an agency relationship or a trust relationship.  At issue in In re Downey Financial Corp.  2015 WL 307013  (C.A.3 (Del.),2015) was the division of over $370 million in tax refunds held in the holding company’s estate, and if its subsidiaries would receive their full portion of the refund or merely an unsecured claim for that portion of the refund.  The Third Circuit held that under California law, the tax-sharing arrangement unambiguously created a debtor-creditor relationship as the lack of any right of the subsidiaries to control the actions of the parent company precluded an agent relationship.  Furthermore, the lack of any discussion of trusts, beneficiaries, or trustees precluded a finding that the contract created a trust relationship.  This decision contributes to the ambiguity regarding tax-sharing arrangements in bankruptcy, as different circuits applying different state law have reached opposite conclusions from similar language in the agreements.  This ambiguity reinforces the need for any group of companies with a tax-sharing arrangement to clarify the treatment of any refund in bankruptcy to provide certainty to their creditors and to avoid the dissipation of assets litigating the issue in any future bankruptcy proceeding.

 

Another wrinkle has emerged in the ever-evolving business of buying creditors’ claims against bankrupt entities.  In a recent decision the Court of Appeals for the Third Circuit held that a debtor can use Bankruptcy Code section 502(d) to disallow a claim from a creditor that had received preferential payments within 90 days of the bankruptcy, even if that claim were subsequently sold to an innocent third party.  In re KB Toys Inc., No. 13–1197, — F.3d — (3d Cir. November 15, 2013).  The Third Circuit’s decision contrasts with a 2007 decision by the District Court for the Southern District of New York, and it raises new potential risks and burdens for anyone buying claims.

Under the bankruptcy code, a trustee can “avoid” preferential payments to creditors and recover the transferred assets for the benefit of the estate’s other creditors.  The trustee can also use Bankruptcy Code section 502(d) to disallow the claims of a creditor unless and until it returns the preference to the estate.

In 2007, the Southern District of New York was presented with the issue of whether a trustee could still use section 502(d) to disallow claims after the creditor that had received the avoidable preference sold them to an innocent third party.  Overruling two previous bankruptcy court decisions that allowed trustees to disallow such claims, the District Court ruled that a third party who bought a claim, with no knowledge of the preference, would not be subject to section 502(d).  In re Enron Corp., 379 B.R. 425 (S.D.N.Y. 2007).  This decision removed a substantial source of risk for parties buying claims from creditors in bankruptcy, especially when information about a potential claim is limited and the price of delay can be high.

In KB Toys, the Third Circuit came to the opposite conclusion, finding that section 502(d) applies to a claim no matter who currently owns it.  Whether bought with knowledge of the preference or without, the claim can be disallowed until the preference is returned.  That is good news for trustees and for creditors who didn’t receive a preference, because it will help prevent creditors from taking advantage of their influence to get an outsized portion of the estate, but potentially bad news for claims traders, who will be taking on the risk that the claims they are buying might be rendered worthless by section 502(d).

It is too early to tell how the other circuits will respond, but KB Toys is likely to impact the business of buying and selling claims.  Any party buying claims, but especially those operating in the Third Circuit (which includes Delaware, New Jersey, and Pennsylvania) should consider prompt steps to protect themselves.  The KB Toys and Enron courts disagreed about where the burden of 502(d) should fall, compare In re Enron Corp., 379 B.R. at 448 (“the burden and risk is better carried by creditors as a whole in favor of the bona fide purchaser in the context of a sale”), with In re KB Toys Inc., — F.3d at *5 (“[the buyer] could have protected itself from the risk of disallowance by . . . performing due diligence on the Original Claimants”), but by closely scrutinizing claims and by adding indemnity provisions to their transfer agreements, savvy parties can put the burden of disallowance where it belongs – on the creditors who received the avoidable preferences in the first place.