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SCOTUS considers Bankruptcy Code priorities and ‘structured dismissals’ in WARN Act claim

By Pamela Wolf, J.D. and Ronald Miller, J.D.

The Supreme Court heard oral argument in a case that could have very broad implications for the trending Chapter 11 bankruptcy resolution known as a “structured dismissal,” which in this case did not adhere to the Bankruptcy Code’s priority system. The deviation here meant that a certified class of nearly 1,800 drivers (the petitioners) received not a dime on their state and federal WARN Act claims, even though lower-priority creditors were paid by the estate. At least some of the Justices were concerned about whether the deviation from the priority scheme here represented the “rare case,” as the attorney for the respondents contended.

Below, in In re: Jevic Holding Corp., the Third Circuit ruled that the bankruptcy court had sufficient reason to approve the settlement and structured dismissal of the employer’s Chapter 11 case. The distribution of the employer’s remaining $1.7 million to all creditors—except drivers—was permissible because the alternative of continued litigation presented too much risk for the bankruptcy estate.

The backstory. Beginning in 2006, the business of the trucking firm, Jevic Transportation, began to decline. In June 2006, Jevic was acquired by Sun Transportation, a subsidiary of Sun Capital, in a leveraged buyout that included an $85 million revolving credit facility. The buyout was financed by CIT Group. Jevic could access the credit line as long as it maintained at least $5 million in assets and collateral. The company continued to struggle in the two years that followed; however, it was able to reach a forbearance agreement with CIT—which included a $2 million guarantee by Sun—to prevent CIT from foreclosing on the assets securing the loans.

By May 2008, with the company’s performance stagnant and the expiration of the forbearance agreement looming, Jevic’s board of directors authorized a bankruptcy filing. The company ceased substantially all of its operations, and its employees received notice of their impending terminations on May 19, 2008. The next day, Jevic filed a voluntary Chapter 11 petition.

Lawsuits filed. Two lawsuits were filed in the bankruptcy court. A group of Jevic’s terminated truck drivers filed a class action against Jevic and Sun alleging violations of federal and Delaware Worker Adjustment and Retraining Notification (WARN) Acts, under which Jevic was required to provide 60 days’ written notice to its employees before laying them off. The creditors’ committee also brought a fraudulent conveyance action against CIT and Sun on the estate’s behalf, alleging that Sun, with CIT’s assistance, “acquired Jevic with virtually none of its own money based on baseless projections of almost immediate growth and increasing profitability.”

Creditor committee settlement. Ultimately, the committee, Jevic, CIT, and Sun reached a settlement agreement that accomplished four things. First, those parties would exchange releases of their claims against each other and the fraudulent conveyance action would be dismissed with prejudice. Second, CIT would pay $2 million into an account earmarked to pay Jevic’s and the committee’s legal fees and other administrative expenses. Third, Sun would assign its lien on Jevic’s remaining $1.7 million to a trust, which would pay tax and administrative creditors first and then the general unsecured creditors on a pro rata basis. Lastly, Jevic’s Chapter 11 case would be dismissed.

Before the Justices. The problem now laid at the feet of the Justices is that the settlement left out the drivers even though they had an uncontested WARN Act claim against Jevic. The drivers had never had an opportunity to present a damages case in the bankruptcy court, which they estimated to have been worth $12.4 million, of which $8.3 was a priority wage claim. The drivers and the bankruptcy trustee objected to the proposed settlement and dismissal mainly because it distributed property of the estate to creditors of lower priority than the drivers. The trustee also objected on the ground that the Code does not permit structured dismissals, while the drivers further argued that the committee breached its fiduciary duty to the estate by “agreeing to a settlement that, effectively, freezes out the [Drivers].”

In oral argument, Attorney Danielle Spinelli, of Wilmer Cutler Pickering Hale and Dorr LLP, argued on behalf of the drivers, and framed the problem neatly for the Court:

“Chapter 11 provides one way to distribute estate assets to creditors on account of their prepetition claims through a confirmed plan that adheres to the code’s priority scheme. If a Chapter 11 plan can’t be confirmed, the bankruptcy court can convert the case to Chapter 7, which also requires that creditors be paid in order of priority, or it can simply dismiss the case without distributing assets to creditors at all, returning all parties to their pre-bankruptcy position.

“No provision of the Bankruptcy Code permits what happened here: an order dismissing a Chapter 11 case that distributed all the estate’s assets to creditors, but deliberately skipped over our clients’ priority claims.”

Left out in the cold. In response to a question posed by Justice Sotomayor, Spinelli stated that the settlement did not bar the drivers from suing the debtor on the WARN Act claims. But there was no money left to the debtor and the settlement did bar the drivers from suing Sun Life for fraudulent transfer, which Spinelli saw as critical. “What this settlement did is it took away our client’s right to pursue either the debtor or Sun and CIT on account of their undisputed WARN Act claims, which were in the area of $12 million.”

Justice Alito queried what practical difference the case might make, other than upholding the law. Spinelli said that on remand, her clients “will have an opportunity to recover on account of their undisputed WARN Act claims, which, as of now … they have been deprived of.” To the Justice’s follow-up inquiry, Spinelli clarified, “if this case went back on remand and were converted to Chapter 7, then the fraudulent-transfer action could be pursued.”

What exactly is the question? Alito also noted a difference between the question framed in the petition for certiorari and the one addressed in the drivers’ merits brief. “The question that you asked us to take was whether a bankruptcy court may authorize the distribution of settlement proceeds in a manner that violates the statutory priority scheme. And you said there’s a square conflict on that issue, with the Second Circuit and the Third Circuit on one side and the Fifth Circuit on the other side,” he said.

“But then the question that you address in your brief refers to “structured dismissal,” Alito pointed out. “There is nothing about structured dismissal in the question that you asked us to take, and there is no conflict on the question of structured dismissal, is there?”

Spinelli explained that the drivers are “not asking this Court to decide the question of whether structured dismissals are valid,” saying also that they had not changed the substance of the question presented.

Unconvinced, Alito said: “Now, you’re not asking us to decide the broad question whether there can ever be a structured dismissal. But you are asking us to decide whether the priorities have to be followed in a structural dismissal, and unless the answer to that question follows from the answer to the question that you presented in your petition, you have changed the question that you have asked us to decide.”

“In the petition, we had a paragraph of background explaining that this was done through a structured dismissal,” Spinelli replied. “We then asked the question, does the Bankruptcy Code—may a bankruptcy court authorize the distribution of settlement proceeds in a manner that violates the Code’s priority scheme?”

“The basic question in this case has always been the same: Was the bankruptcy court entitled under the Bankruptcy Code to authorize this distribution of settlement proceeds, which are estate assets, in violation of priority?,” Spinelli stressed.

Do priorities apply to settlements? Justice Breyer agreed, but, noting that the petitioners had contended that nothing in the Code permits this type of settlement, he reframed the question to what forbids it? The Justice agreed that the Code didn’t permit it, but saw the problem as “what forbids it?”

Laying out the steps in the business bankruptcy process, Spinelli said, “Those careful, reticulated mechanisms for the distribution of estate assets foreclose any inference that Congress intended to allow courts to disregard them and create a different method for distributing assets that’s not mentioned anywhere in the Code that violates that…backbone priority scheme.”

Justice Kagan asked why it is not mentioned in the Code and whether Congress just didn’t think it might happen. Spinelli asserted, “the reason that Chapter 11 doesn’t expressly apply the priority rules to settlements is that settlements are not intended to be a method of distributing estate assets.” She stressed the difference between the settlement of a cause of action belonging to the estate and distribution of all the estate’s assets, including the settlement proceeds. “So Congress would not have specified that priority applies to settlements, because settlements are not a means for distribution of estate assets.”

“Cause” provision. Justice Kennedy pointed to the Code’s “cause” provision, that permits the court to alter the normal effects of dismissal, returning all parties to their prebankruptcy position, citing the Code’s language, ‘“unless the Court, for cause, orders otherwise.”’ The Justice asked Spinelli why it did not apply here, as the respondents contend.

According to Spinelli, “what the legislative history tells us is that the ‘for cause’ provision in Section 349(b) was intended to protect parties who took actions in reliance on the bankruptcy.”

No priority deviation without consent. The federal government as amicus curiae supporting the petitioners, represented by Sarah E. Harrington, Assistant to the Solicitor General, argued, “the Court should hold that a bankruptcy court can never resolve a bankruptcy by ordering the distribution of estate assets in a manner that violates the Code’s detailed priority system without the consent of the impaired priority claimholder.”

Chief Justice Roberts asked whether the government would include the “extraordinary circumstances exception.” “No,” Harrington answered, explaining that “basically, the extraordinary circumstances exception that the Third Circuit wanted to apply would bring in any case that is administratively insolvent, and that’s a large proportion of business bankruptcies. That kind of exception also gives parties the…wrong incentive to make essentially self-serving assertions about what they would or would not do if the particular disposition that they desire is not approved.”

Harrington clarified that certain previously discussed prepetition distributions were a separate question. “In our view, the ‘priority scheme’ is sort of a broad term that includes both equitable subordination law, subordination principles, which are not applicable here, and also includes the ability of the priority claimholder to consent to impairment of its rights,” Harrington explained. “I think it’s important to keep in mind here that the priority claimholders here, petitioners, did not settle. This is not a case where the people whose rights were impaired agreed to it, and you can’t…call a settlement basically the agreement of other parties whose rights were not impaired and who, in fact, benefited from the impairment of the petitioners’ rights.”

Evasion of plan requirements. Kirkland & Ellis’ Christopher Landau, arguing for the respondents, asserted that “the Code speaks to when the absolute priority rule applies in Chapter 11, and it applies to plans.” Dispositions of assets before plans, he said, are subject to judicial review. “The use, sale, and lease of…assets is subject to judicial review under Section 363(b), but that is a discretionary standard.” He also stressed that in applying the discretionary standard, “it’s absolutely critical” to ensure there is no evasion of requirements for a plan. He said that the Second and Third Circuits have recognized that it’s a rare case where this is true.

Landau’s “rare case” statement prompted a quick response from Justice Sotomayor, who said she didn’t know why this is a rare case: “I mean, every structured settlement of this kind is trying to exclude one set of creditors.”

“And this is exactly what this did, and it did it in collusion among the senior and junior creditors to the exclusion of the disfavored creditor,” Sotomayor continued.

Judicial approval. Justice Breyer asked whether at least on request, in a Chapter 11 case, the judge must approve a settlement.

Landau said the judge does not have to approve the settlement per se because there is no provision in the Code that requires it. He also clarified that just because there is no Code provision for approving settlements qua settlements (there was under the old Code regime) doesn’t mean that in a settlement actually disposing of estate assets, like this settlement did, that the disposition of assets is not subject to traditional Rule 363(b) review by the court of any use, sale, or lease.

Power to change distribution order. Continuing, Breyer queried where the bankruptcy trustee or any court gets the power to say that a group of people can reverse the order in which assets will be distributed, characterizing the question as the thing that is bothering the Justice, presumably the federal government, and the workers in this case.

Landau acknowledged that as a general rule the trustee and court can’t reverse the order of distribution. “But this case explains exactly why [In re Iridium Operating, LLC (2d Circ. 2007)] said there may be some rare exceptions, because once you are in this more discretionary 363(b) land, the…priority scheme is going to be the most important,” he said. “This case is a great example, Your Honor, because in this case we have findings that there could be no confirmable Chapter 11 plan because the estate was administratively insolvent. So the Code system that you just described, the waterfall of priorities, would not apply in Chapter 11 because there was no way to go to a Chapter 11 plan.”

Justice Kennedy, however, interjected, “but I’m sure it often happens that there can be no confirmable plan because the creditors—priority creditors—are not going to concede. So that happens all the time when you go through Chapter 7.”

“[S]o this is not a rare case,” Kennedy said, echoing Justice Sotomayor’s similar point.