The recent U.S. Supreme Court decision in the case of Czyzewski et al. v Jevic Holding Corp. et al. has a significant impact on hedge funds and other secured lenders—especially those providing funding to leveraged buyouts (LBO).
Jevic was an interstate trucking company that had been the subject of an LBO, which is where the assets of an entity are used as collateral for a loan and the loan proceeds are used to purchase the stock of the entity. In such a situation, from a technical accounting standpoint, immediately after the LBO has been completed, the entity is insolvent from a balance sheet perspective, as the debt to acquire the stock has created no tangible asset benefit to the entity which now must service the principal and interest on the new loan. Historically, unless an entity that has been subject to an LBO creates huge new profits or sells off portions of the business to raise cash, the entity either goes back to being a public entity to pay the debt or defaults on its obligations.
When Jevic was no longer able to service its debt load from the LBO and continue to operate its business, it sought protection under Chapter 11 of the Bankruptcy Code. Since the assets of the company had a value that was less than the outstanding secured debt, it appeared that only the lender would receive any distribution from the bankruptcy proceeding. This created a legal issue as well as a practical one, as the company wanted to pay some of its unsecured creditors passing over priority claims that had been awarded to the truck drivers based upon Jervic’s failure to comply with notice requirements under the WARN Act.
In Chapter 11, the Bankruptcy Code has a strict payment scheme which is called the absolute priority rule. Under this statutory mandate, unless creditors of a higher class entitled to payment either receive payment in full or agree to accept less than payment in full, creditors of a lower class entitled to payment may not receive a distribution through the bankruptcy plan process. Over the years, this has presented a problem when an entity needing Chapter 11 relief has significant priority debt which would preclude a distribution to lower classes of creditors such as vendors, unsecured lenders and others.
In order to circumvent the absolute priority rule, a process known as a structured dismissal was created. Under a structured dismissal, all of the assets or equity of the company in Chapter 11 would be distributed to the secured creditor and the secured creditor would voluntarily make distributions to selected junior creditors, skipping over creditors in priority classes. As part of the structured dismissal, the bankruptcy court would approve the distribution process, give releases to third parties that may otherwise be obligated and effectively condone the circumvention of the absolute priority rule in the court order dismissing the Chapter 11 case. As a result of many bankruptcy courts approving the structured dismissal process, it became a somewhat accepted method to manipulate the process to the detriment of employees, taxing authorities and others entitled to statutory priority.
The truck driver creditors of Jevic appealed to the US Supreme Court the approval of the structured dismissal of the Chapter 11 case that skipped over them in the payment scheme. Those involved with the bankruptcy process were extremely interested in how the US Supreme Court would deal with this issue, since there are other procedures, such as the approval by the bankruptcy court for the payment of critical vendors, critical employees, retention bonus incentives and the like which also technically circumvent the bankruptcy payment statutory scheme.
In a narrowly worded opinion, Justice Breyer, speaking for the majority of the Supreme Court, held that the use of a structured dismissal by a bankruptcy court order to circumvent the statutory requirement for payment by classes of creditors was a violation of the Bankruptcy Code and will no longer be permitted as part of the bankruptcy process. The opinion did not deal with any other procedures used to pay individual or classes of creditors during the Chapter 11 case, and the impact of the decision is limited to structured dismissals.
Nevertheless, this will have significant hedge funds and other secured lenders when contemplating loans to finance an LBO or other asset based loans that have a high risk factor. Traditionally, although the anticipation by the lenders is that the loan will be amortized on a timely basis and in full at maturity, there has been the knowledge and expectation that should there be a default or unforeseen circumstances arise, a quick “in and out” structured dismissal bankruptcy proceeding could be utilized in order to not only have the secured lender take back the assets or equity of the debtor free of all other obligations, but also to be able to satisfy those junior creditors believed to be necessary for an ongoing operation. Furthermore, as a result of the Supreme Court decision, unsecured creditors, labor unions and other subordinated debt holders will be empowered with enhanced bargaining power should the need for a bankruptcy reorganization arise.
From a purist’s standpoint, the Supreme Court’s decision is consistent with the Congressional intent of the current Bankruptcy Code when it was enacted in 1978. However, many believe that what has transpired with the multinational economy in the almost four decades since the Bankruptcy Code was an enacted cry out for a modernization to deal with today’s economic environment.
Charles M. Tatelbaum is an international law expert and senior attorney in the bankruptcy and creditors’-rights department at the Tripp Scott law firm.