by Nathan Gencarella 1
Inherent in the concept of bankruptcy is the presumption that no process could make every party with a claim to a debtor’s property whole.2 As such, a fundamental purpose of the Bankruptcy Code is to establish priorities among creditors to ensure that the debtor’s assets are distributed in a manner that equitably balances the competing interests of affected parties based on ex ante policy determinations, rather than the inside influence or economic leverage of a particular equity holder or creditor ex post.3 These congressional priorities are reflected in section 507 of the Bankruptcy Code, which outlines a detailed hierarchy of claims that guides the distribution of property in bankruptcy proceedings,4 and in the absolute priority rule set forth in section 1129, which ensures that no plan will be confirmed in a Chapter 11 reorganization proceeding that deviates from the priority scheme without the consent of a disadvantaged class.5
However, notwithstanding the seeming universality of the Code’s priority scheme, parties to Chapter 11 proceedings that stand to gain from priority-skipping distributions have sought to evade its strictures by creatively structuring agreements to avoid formally distributing property pursuant to a final plan.6 Proponents of this approach argue that because the absolute priority rule only expressly governs the distribution of estate property under a Chapter 11 plan, the rule does not implicate priority-skipping distributions that occur outside of a final plan or that involve property that is rightfully owned by the creditor distributing the assets. 7 Moreover, some courts argue that these purported exceptions to the absolute priority rule are grounded in sound policy, as they allow parties to accelerate the Chapter 11 proceedings, maximize the value of the estate where a priority-skipping distribution is the only way to avoid liquidation, and overcome potential hold-out problems that arise if a class of creditors could in effect veto any priority-skipping compromise. By holding that all property distributions must strictly abide by the Code’s priority scheme when tied to a structured dismissal, however, the Supreme Court’s recent decision in Czyzewski v. Jevic casts substantial doubt on the continued validity of purported exceptions to the absolute priority rule.8
Ultimately, this Contribution will argue that to preserve the integrity of the Bankruptcy Code’s priority scheme and to protect the statute’s carefully drawn balance between competing interests in Chapter 11 proceedings, courts should refuse to read into the Bankruptcy Code a pre-plan gift settlement exception to the absolute priority rule.
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The Bankruptcy Code establishes a comprehensive system of priority governing the distribution of property in Chapter 11 proceedings that expressly prohibits parties with subordinate claims from receiving any property on account of a claim or interest in the debtor’s estate over the objection of a more senior class until that class’s claims are satisfied. 9 Specifically, under section 1129(b), Chapter 11 plans that attempt to circumvent the Code’s priority scheme without the consent of a disadvantage class must be rejected by the bankruptcy court because such plans fail to meet the “fair and equitable” threshold required for confirmation as a matter of law.10 However, while the Supreme Court has extended this bright-line prohibition on the approval of priority-skipping plans to settlement distributions made pursuant to a dismissal of a Chapter 11 proceeding,11 it has yet to provide guidance on whether pre-plan gift settlements likewise fall within the scope of the absolute priority rule. Similarly, no circuit has yet been presented with a case involving a gift distribution made in the context of a pre-plan settlement.
Proponents of a general gifting exception to the absolute priority rule argue that an undersecured senior creditor is allowed to “gift” the proceeds of its collateral to classes with inferior claims without regard to the Code’s priority scheme because such creditors have an undisputed claim to the estate’s property and should have the right to dispose of it as they wish.12 However, while the Third Circuit in In re ICL Holding Co. held that secured creditors may gift non-estate property without triggering the absolute priority rule,13 no circuit has upheld a gifting arrangement that distributes estate property in violation of the Code’s priority scheme.14 Indeed, the Second Circuit, the only circuit to directly address the issue of gifting estate property in the context of Chapter 11 proceedings, found that neither the plain language nor legislative history of section 1129 supports the creation of a gift exception to the absolute priority rule.15
Where the Courts of Appeals have diverged, however, is whether distributions made pursuant to a pre-plan settlement are subject to the full force of the absolute priority rule. Although the Supreme Court in TMT Trailer Ferry, Inc. v. Anderson16 held that settlements that are incorporated into a reorganization plan must be “fair and equitable” – a standard that the Court observes “incorporates the absolute priority doctrine”17 – the Court has not yet resolved whether this rule applies to pre-plan settlement agreements. Therefore, though every circuit to have addressed this issue agrees that pre-plan settlements must be fair and equitable to be approved by the bankruptcy court under Rule 9019 of the Federal Rules of Bankruptcy Procedure, a split has arisen over whether the “fair and equitable” standard applicable to pre-plan settlements fully incorporates the absolute priority rule. While the Second Circuit would grant bankruptcy courts the discretion to approve priority-skipping pre-plan settlements if the settlement “was a step towards possible confirmation of a plan of reorganization and not an evasion of the plan confirmation process,”18 the Fifth Circuit in In re AWECO19 embraced a bright-line rule that bankruptcy courts must reject a pre-plan settlement that entails a priority-skipping distribution “unless the court concludes that priority of payment will be respected as to objecting senior creditors.”20 At the heart of this split is the question of whether the text of the statute and the significant risk that parties will exploit any loophole that is created in the Code’s absolute priority scheme compel the court to strictly enforce its requirements in evaluating pre-plan settlement agreements or whether a per se rule is too rigid to effectively accommodate the often dynamic and amorphous nature of the early stages of Chapter 11 proceedings.
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Because the absolute priority rule is essential to the fair and equitable distribution of property in Chapter 11 proceedings,21 the Supreme Court has declared that one should “expect more than simple statutory silence if, and when, Congress were to intend a major departure.”22 Parties to a Chapter 11 proceeding cannot evade its strictures by doing via a pre-plan gift settlement what Congress has expressly prohibited them from doing pursuant to a final plan for four reasons.
First, the text of section 1129 is inconsistent with reading a gifting exception into the absolute priority rule. As the Second Circuit explained in In re DBSD, “the Code extends the absolute priority rule to any property, … not any property not covered by a senior creditor’s lien. The Code focuses entirely on who receives or retains the property under the plan, not on who would receive it under a liquidation plan.”23 Therefore, the fact that a secured creditor would have the right to receive the property at issue under the Code’s priority scheme is simply immaterial to a determination of whether it complies with Chapter 11’s absolute priority rule. Rather, the plain language of section 1129 precludes parties with a junior interest from receiving any property on account of that interest that violates the statute’s carefully balanced priority scheme.24
Second, even if the text were ambiguous, the historical development of the absolute priority rule belies the notion that a “gift settlement” exception to absolute priority rule could be consistent with the statute. The absolute priority rule was originally developed by the Supreme Court in the context of railroad reorganizations to prevent senior creditors from squeezing out intermediate creditors by giving up value or an equity stake in the newly reorganized entity to buy the cooperation of old equity.25 In other words, the absolute priority rule was designed to prevent the very sort of gifting exception being advocated for today. While the railroad cases are no longer binding precedent given that the common law rule has now been codified by Congress, it strains credulity to conclude that Congress would abrogate “the more-than-a-century old core of the absolute priority rule by passing a statute whose language explicitly adopts it.” 26
Third, the mere fact that a gifting arrangement is made pursuant to a pre-plan settlement, rather than as part of a reorganization plan, does not cure the violation of the Code’s priority scheme. As the Fifth Circuit rightly recognized in the matter of AWECO, failing to apply the absolute priority rule to pre-plan settlements would grant bankruptcy courts the discretion “to favor junior classes of creditors so long as the approval of the settlement came before the plan.” 27 Creating such an arbitrary distinction would allow parties to evade fundamental procedural protections written into the Bankruptcy Code by the mere formality of structuring priority-violating distributions as pre-plan settlements as opposed to tying them to final distributions under a plan or structured dismissal.
Finally, preserving the integrity of the absolute priority rule is essential as a matter of public policy. The hierarchy of claims detailed in section 507 reflects carefully balanced value and policy judgments made by Congress with respect to what classes of interests deserve priority when distributing the debtor’s property.28 Ensuring that the priority scheme is respected in pre-plan settlement agreements protects the reliance interests of parties who reasonably believe that the Code’s priority system will govern distributions in the event of bankruptcy, incentivizes the infusion of new capital in a reorganization entity by ensuring that administrative priority claims will be protected,29 minimizes the risk that employees will abandon a failing business out of fear of not being paid,30 and is the most equitable result as it reflects the priority of claims that parties bargained for ex ante.31 Moreover, maintaining a clear, bright-line rule minimizes litigation costs by facilitating settlements.32
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Because bankruptcy proceedings are presumptively unable to fully compensate every party with a claim or interest in the property of the estate, it is imperative that distributions of estate property be distributed in a fair and equitable manner. Although applying the absolute priority rule to pre-plan gift settlements may appear to impede the efficient resolution of disputes, enforcing a robust version of absolute priority advances the interests of all creditors by encouraging investment in reorganizing entities, protecting reliance interests that parties bargained for ex ante, and facilitating settlements by maintaining a clear, predictable rule. Moreover, strict adherence to the absolute priority rule in pre-plan settlement agreements is essential to ensure that parties to a Chapter 11 proceeding cannot evade the requirements of section 1129(b) simply by altering the timing of a priority-skipping distribution. Therefore, in order to protect the Code’s carefully calibrated hierarchy of competing interests and ensure the vitality of the absolute priority rule in reorganization proceedings, courts should reject any pre-plan gift settlement that seeks to distribute property in violation of the Code’s priority scheme.
1. Nathan Gencarella is a 3L at New York University School of Law.This piece is a commentary on the 2018 problem at the Duberstein Moot Court Competition in Queens, NY, hosted by St. John’s University School of Law. The issue in the problem dealt with whether a bankruptcy court may approve a contested “gift” settlement involving a payment by a section 363 purchaser in connection with the acquisition of the debtor’s assets when the settlement proceeds are not distributed in accordance with the Bankruptcy Code’s priority scheme. The views expressed in this article do not necessarily represent the views of the author on this point of law. Rather, this article is a distillation of one side of the arguments made by the team at the Duberstein Moot Court Competition.
2. See Elizabeth C. Warren, Bankruptcy Policy, 54 U. Chi. L. Rev. 775, 785 (1987).
3. Id.; see also Czyzewski v. Jevic Holding Corp., 137 S. Ct. 973, 986 (2017) (observing that the bankruptcy code’s scheme has “long been considered fundamental to [its] operation” as it ensures that the debtor’s assets are distributed “in an orderly manner … in accordance with established principles rather than on the basis of the inside influence or economic leverage of a particular creditor”) (internal citations omitted); Roe & Tung, Breaking Bankruptcy Priority: How Rent-Seeking Upends The Creditors’ Bargain, 99 Va. L. Rev. 1235, 1243, 1236 (arguing that “the first principle of bankruptcy is that ‘distribution conforms to predetermined statutory and contractual priorities”).
A business may file for bankruptcy directly under either Chapter 7, for liquidation, or Chapter 11, which governs business reorganizations. See William L. Norton Jr., Norton Bankruptcy Law. & Practice § 11:1 (rev. 3d ed. Supp. 2018). At the point that a business files for bankruptcy, an estate is created that “includes all of the debtor’s legal or equitable interest in property at the time of the filing of the petition wherever located and by whomever held.” Id. § 3:11. In a Chapter 7 proceeding, a trustee is appointed to collect and liquidize the property of the estate and then to distribute the proceeds to the creditors. See Norton, supra, § 3:12. The debtor retains no control over the entity once the proceeding commences and the process will end with the entity being dissolved. See id. In a Chapter 11 proceeding, by contrast, a debtor generally retains control to operate the business as the “debtor-in-possession” throughout the process. See id. § 3:14.
4. See 11 U.S.C. § 507 (West 2012).
5. See 11 U.S.C. § 1129 (West 2012); see also Norton, supra note 3, § 3:14 (“Absolute priority … ‘requires that the plan pay any dissenting class in full before any class junior to the dissenter may be paid at all.’” (quoting H.R. Rep. No. 95–595., 1st Sess. 224 (1977))).
6. See Sally Henry, Chapter 11 Zombies, 50 Ind. L. Rev. 579, 593–606 (2017) (describing the methods employed to evade the standard priority and equality rules).
7. See, e.g., Motorola, Inc. v. Official Comm. of Unsecured Creditors (In re Iridium Operating LLC), 478 F.3d 452, 467 (2d Cir. 2007) (holding that “the bankruptcy court, in its discretion, could endorse a settlement that does not comply in some minor respects with the priority rule if the parties to the settlement justify, and the reviewing court clearly articulates the reasons for approving, a settlement that deviates from the priority rule”). This argument forms the basis of so-called “gift” settlements made by secured creditors, which traditionally are comprised of priority-skipping distributions taken from the proceeds of their collateral to buy peace through a pre-plan settlement agreement. See Henry, supra note 6, at 600–02.
8. See Czyzewski, 137 S. Ct. at 987.
9. See §§ 507, 1129(b).
10. See § 1129(b)(2)(B).
11. See Czyzewski, 137 S. Ct. at 987.
12. See, e.g., In re Genesis Health Ventures, Inc., 266 B.R. 591, 602 (Bankr. D. Del. 2001) (approving priority-skipping distributions made by senior creditors under a reorganization plan because those creditors were entitled to receive the entire value of the debtor’s estate under the ordinary priority rules); In re MCorp Financial, Inc., 160 B.R. 941 (S.D.Tex. 1993) (holding that senior creditors “may share their proceeds with creditors junior to [an intermediate class], as long as [the intermediate class] continue[s] to receive as [sic] least as much as what they would without the sharing”).
13. See In re ICL Holding Co., 802 F.3d 547, 555–56 (3d Cir. 2015) (reasoning that the gifting arrangement at issue did not implicate that absolute priority rule because it did entail a distribution of estate property).
14. The First Circuit’s decision in Official Unsecured Creditors’ Committee v. Stern (In re SPM Manufacturing Corp.), 984 F.2d 1305, 1313 (1st Cir. 1993) is not to the contrary. As a threshold matter, In re SPM could never be used to justify a gifting exception to Chapter 11’s absolute priority rule because that case arose under a Chapter 7 liquidation. This is fatal to any attempt to apply its holding to the Chapter 11 context because Chapter 7 is not governed by the absolute priority rule. See In re DBSD North America, Inc., 634 F.3d 79, 98 (2d Cir. 2011). Moreover, even if the rationale of In re SPM were applicable to a Chapter 11 gift settlement, the gifting arrangement at issue only distributed non-estate property. See also In re ICL Holding Co., 802 F.3d 547, 558 (3d Cir. 2015) (holding that where gifts do not distribute estate property, secured creditors need not comply with the Code’s priority scheme).
15. See In re DBSD North America, Inc., 634 F.3d 79, 95–99 (2d Cir. 2011) (holding that while undersecured senior creditors may “demand a plan in which they receive all of the reorganized corporation, … having chosen not to, they may not surrender part of the value of the estate for distribution [to a subordinate class] as a gift) (internal citations omitted).
16. 390 U.S. 414 (1968).
17. Id. at 441.
18. In re Iridium, 478 F.3d at 467.
19. 725 F.2d 293 (1984).
20. Id. at 298 (noting that “fair and equitable” are terms of art that “mean that ‘senior interests are entitled to full priority over junior ones’” (quoting SEC v. American Trailer Rentals Co., 379 U.S. 594 (1965))).
22. Czyzewski v. Jevic Holding Corp., 137 S. Ct. 973, 986 (2017).
23. In re DBSD, 634 F.3d at 97 (first emphasis added; second emphasis in original) (internal citations omitted).
24. See § 1129(b).
25. See In re Iridium Operating, LLC, 478 F.3d 452, 463 n.17 (2d Cir. 2007); see also, e.g., Chi., Rock Island & Pac. R.R. v. Howard, 74 U.S. 392, 409–10 (1868); N. Pac. Ry. Co. v. Boyd, 228 U.S. 482, 507–08 (1913); Henry, supra note 6, at 602.
26. In re DBSD, 634 F.3d at 99.
28. For example, “Congress established employee wage priority to alleviate in some degree the hardship that unemployment usually brings to workers and their families when an employer files for bankruptcy.” Czyzewski, 137 S. Ct. at 986 (internal quotations omitted).
29. See, e.g., Trustees of Amalgamated Ins. Fund v. McFarlin’s, Inc., 789 F.2d 98, 101 (2d Cir. 1986) (“Congress granted priority to administrative expenses in order to facilitate the efforts of the trustee or debtor in possession to rehabilitate the business for the benefit of all the estate’s creditors.… Congress reasoned that unless the debts incurred by the debtor in possession could be given priority over the debts which forced the estate into bankruptcy in the first place, persons would not do business with the debtor in possession, which would inhibit rehabilitation of the business and thus harm the creditors.”); In re Espinosa, 542 B.R. 403, 410 (Bankr. S.D. Tex. 2015) (“The purpose of administrative expenses is clear: sections 503 and 507 .… work in tandem to encourage entities to do business with a debtor post-petition and thus ensure the survival of the estate above all other financial goals.”).
30. See Czyzewski v. Jevic Holding Corp., 137 S. Ct. 973, 987 (2017) (internal citations omitted).
31. See In re THC Fin. Corp., 679 F.2d 784, 785 (9th Cir. 1982) (the absolute priority rule “vindicate[s] the reasonable expectations formed by claimants when their investments or loans were made”).
32. See Czyzewski, 197 S. Ct. at 987 (“[T]he ratio of lawsuits to settlements is mainly a function of the amount of uncertainty, which leads to divergent estimates by the parties of the probable outcome.” (quoting Landes & Posner, Legal Precedent: A Theoretical and Empirical Analysis, 19 J. Law & Econ. 249, 271 (1976))); see also RadLAX Gateway Hotel, LLC v. Amalgamated Bank, 566 U.S. 639, 649 (2012) (emphasizing the importance of clarity and predictability given that the “Bankruptcy Code standardizes an expansive (and sometimes unruly) area of law”).