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In re Jevic: The Supreme Court Reaffirms the Absolute Priority Rule

March 28, 2017 - Last week, in In re Jevic, the U.S. Supreme Court reaffirmed the most fundamental principle in bankruptcy – the absolute priority rule – while at the same time recognizing that flexibility in the bankruptcy process itself is essential.  It was a very important win for secured lenders.

Specifically, in Jevic, the U.S. Supreme Court held that “a distribution scheme in connection with the dismissal of a Chapter 11 case cannot, without the consent of the affected parties, deviate from the basic priority rules that apply under the …Code”.  In so holding, the Court reaffirmed the view that the priority system applicable to distributions under Chapters 7 (liquidation) and 11 (reorganization) of the Code “has long been considered fundamental to the Bankruptcy Code’s operation,” and that the “priority system constitutes a basic underpinning of business bankruptcy law.”  Importantly, the Court’s holding was very narrow; while prohibiting non-consensual, class-skipping distributions in the context of structured dismissals, it did not rule out structured settlements generally and went to great lengths to validate interim distributions to critical vendors, employees and others that might violate ordinary priority rules.  Recognizing the importance of this case and its potential impact on the absolute priority rule, the LSTA in September 2016 submitted an amicus brief in support of the successful petitioners. 

The case is so important that on Wednesday, March 29th, the LSTA held a webcast to discuss it.  The slides, supporting documents and replay are available here. 

Following is a deeper dive into Jevic.  What happened, how the courts below ruled, what the Supreme Court said (and what it didn’t say), and what are the implications for bankruptcy practice in the wake of Jevic

The basic facts:  

In 2008, two years after a failed leveraged buyout, Jevic Transportation, a trucking company, filed chapter 11 in Delaware owing $53 million to its sponsors and secured lenders and $20 million in priority taxes and to its unsecured creditors.  Just before filing, Jevic terminated thousands of drivers with little or no notice, seemingly in violation of the WARN Act which requires an employer to give employees 60 days’ notice prior to termination.  The drivers obtained a summary judgment against the company on their WARN Act claims and a portion of those damages constituted priority claims in bankruptcy that ranked above general unsecured creditors.  The drivers also sued the sponsor and the banks under the WARN Act (an action that was ultimately resolved in favor of the sponsor and the banks).

Separately, the creditors committee sued the sponsor and the lenders on the grounds that the entire leveraged buyout constituted a fraudulent transfer and sought to subordinate the sponsor’s and lenders’ secured claims.  By then, all the company’s assets had been sold and were applied as partial payment of the secured creditors and all that remained was $1.7 million of cash and the committee’s litigation claims against the sponsor and lenders. 

The sponsor, the banks and the unsecured creditors entered into negotiations to settle the litigation claims and reached an agreement in which the banks would pay the unsecured creditors $2 million and assign their lien on the cash to a trust to pay taxes and administrative expenses.  The drivers were purposely excluded from the settlement (in order to avoid funding their litigation against the sponsor and the banks) and received nothing for their priority WARN Act claims.  Over the objection of the drivers the settlement was approved by the bankruptcy court which then dismissed the Chapter 11 case.  Those decisions were affirmed on appeal by both the District Court and a panel of the Third Circuit.  

The Supreme Court’s decision

The Supreme Court reversed and remanded in a 6-2 decision written by Justice Breyer, holding that creditor priorities provided for in the Code must be followed in making distributions under a dismissal. (It is worth noting that the two Justices who dissented did so on procedural grounds; they did not weigh in on the merits).  

The Court first made short shrift of Jevic’s argument that the petitioners lacked standing because they were not harmed by the structured dismissal.  The Court found that the record did not support the proposition that the drivers could suffer no loss and therefore standing existed. 

The Court then addressed the merits, holding that structured dismissals that provide for distributions that do not follow ordinary priority rules cannot be approved without the affected creditors’ consent.  The Court homed in on the importance of the priority system to the Code.  It noted that distributions in Chapter 7 liquidations must absolutely follow the priority scheme and although there is some flexibility with Chapter 11, it, too, largely follows strict priority.  It concluded that Congress would not have been silent on the issue of priority if it intended to allow structured dismissals as a major departure from the priority scheme and found nothing in the Code that evinces this intent.

Importantly, the Court’s holding is narrow.  First, it does not prohibit structured dismissals generally; only non-consensual ones that violate the priority scheme.  Next, it applies solely to departures from the priority scheme at the end of a case. The Court expressly stated (albeit in dicta) that lender rollups, first day wage orders and payments to critical vendors that violate the ordinary priority rules but could benefit the estate would be permitted due to a “significant bankruptcy-related justification.”

The Court ended by noting that Congress did not intend, as the Third Circuit suggested, to authorize a “rare case” exception that could be applied sparingly for sufficient reasons.  It noted, “it is difficult to give precise content to the concept ‘sufficient reasons.’ That fact threatens to turn a ‘rare case’ exception into a more general rule.”

The bottom line

The Supreme Court made an important statement about the importance of the absolute priority rule upon which the entire U.S. bankruptcy scheme rests and secured lenders rely.  It would not permit a deviation from that scheme outside of Chapters 7 or 11 in the context of a final distribution through a structured dismissal.  It did, however, recognize the importance of flexibility in the course of a bankruptcy case and specifically approved of payments to critical vendors and others.  This case has garnered an unusual amount of attention and we direct you to four insightful analyses by Bryan Cave, Bracewell, Arnold & Porter Kaye Scholer, and Kramer Levin

Check back on Thursday as we summarize our Wednesday webinar.

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