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Bankruptcy Settlements may not have to Comply with the Absolute Priority Rule

In the recent Third Circuit decision in In re Jevic Holding Corp. the Court of Appeals ruled that, in rare circumstances, settlements in bankruptcy cases can be approved even if they result in junior creditors receiving a distribution before senior creditors are paid in full (i.e., even if the settlement violates the "absolute priority rule").  The decision is contrary to Fifth Circuit law, but in accord with Second Circuit precedent. The Third Circuit also approved a structured dismissal as an appropriate exit strategy from chapter 11.

The debtor filed for bankruptcy in May 2008 with about $53 million owed to senior secured creditors and over $20 million owed to tax and general unsecured creditors.  Further, a group of the debtor’s former truck drivers alleged WARN Act violations, with a collective claim worth $12,400,000 (of which $8,300,000 was a priority wage claim). The creditors’ committee commenced a fraudulent transfer action against the Secured Creditors based on their participation in an earlier leveraged buy-out of the Debtor.  Ultimately, a settlement was reached that would resolve the committee's action and provide a distribution to unsecured creditors.  The action also contemplated a structured dismissal of the debtor’s bankruptcy case.

The truck drivers, who had uncontested, priority claims, challenged the settlement on two primary grounds: (1) the Bankruptcy Code does not permit structured dismissals; and (2) the settlement distributed money to creditors of lower priority than the drivers.  Both the Bankruptcy Court and the District Court approved the settlement and dismissal.  On appeal, the Third Circuit affirmed.

As to the driver's first challenge regarding structured dismissals, the Third Circuit concluded that structured dismissals are neither authorized by the Code nor prohibited (except when used to circumvent a plan process or a chapter 7 conversion).  It was undisputed in this case that there was no prospect of a plan and that conversion to chapter 7 was a “bridge to nowhere”.  The Court concluded that a structured dismissal was allowable (noting that, in other instances, the prospect of a successful plan or conversion may make structured dismissals an unacceptable option).

The second challenge targeted the settlement—namely, its noncompliance with the absolute priority rule through its payments to creditors junior to the drivers.  The Court analyzed whether settlements needed to comply with the absolute priority rule.  Noting that the Fifth Circuit had held that they must, but that the Second Circuit had implemented a more flexible approach, the Third Circuit held that a flexible approach was preferable (though, they declared it a “close call”)—

bankruptcy courts may approve settlements that deviate from the priority scheme of section 507 of the Bankruptcy Code only if they have 'specific and credible grounds to justify [the] deviation.'

In this case, the facts justified the deviations.  Were the settlement to be disallowed, all but the secured creditors would receive no payment, including the drivers.  With approval, the settlements would provide $1.7 million to the unsecured creditors (though still nothing for the drivers).  Either way (settlement or no) the drivers would get nothing.  Finding itself stuck between the proverbial rock and a hard place, the Court held that the settlement was permissible in the narrow circumstances of the case (the “least bad alternative”).  With that said, the Court was quick to reinforce that the absolute priority rule remained a significant factor to consider in the settlement process—indeed, the “most important factor for a bankruptcy court to consider when determining whether a settlement is ‘fair and equitable’ under Rule 9019.”  However, if all other factors weigh heavily in favor of approval, compliance with the absolute priority rule can be avoided.

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Eric R. Blythe is a Mintz attorney with deep capabilities in commercial litigation and lending, debt restructuring and workouts, distressed debt advising, and corporate and municipal reorganization. His clients have included lenders, secured and unsecured creditors, corporate borrowers, and bondholders.