Absolute Priority Redux: First-Day Orders and Pre-Plan Settlements in Chapter 11 Post-Jevic
William & Mary Business Law Review, v. 10 (2018)
78 Pages Posted: 30 May 2019
Date Written: 2018
This Article considers the problem of priority-skipping distributions made by a chapter 11 debtor outside of a plan, following the Supreme Court’s Jevic decision. The Jevic Court extended the absolute priority rule — which under U.S. bankruptcy enactments dictates the order of distributions to creditors under a chapter 11 cramdown plan and in a chapter 7 liquidation — to a chapter 11 case-ending settlement known as a “structured dismissal.”
The Jevic Court limited its holding to a case-ending settlement. It did not extend the absolute priority rule to an interim or pre-plan settlement or other transaction that is not case-ending or to a “first-day” distribution made at the very beginning of a chapter 11 case. The Court expressed no view about the legality of structured dismissals in general and did not define when a settlement other than a “structured dismissal” is case-ending. It emphasized, without much in the way of details, that the Code’s priority system was a “basic underpinning of business bankruptcy law” that must be safeguarded even with respect to a pre-plan transaction.
This Article considers these issues of pre-plan or “interim” settlements and first-day distributions left open by Jevic. It asserts that Jevic is best characterized as a transaction among insiders and parties asserted to have colluded with them, that assertedly provided for a distribution of estate assets to the settling parties based on their control and collusion, supported by a hypothetical rather than a market valuation of ultimate distributional outcomes. This issue — the use of control and collusion supported by a hypothetical valuation to obtain an unfair distribution or “control premium” — is the precise issue that gave rise to the absolute priority rule 150 years ago and that concerned the Court in 203 N. LaSalle, the last case before Jevic in which the Court extensively considered the absolute priority rule in chapter 11. First-day relief in chapter 11 presents a similar though not identical valuation dilemma: can a hypothetical prediction made early in the case of ultimate distributions to creditors reliably determine that some prepetition claims should be paid at the first-day hearing because such payments ultimately will benefit (or at least will not harm) the remaining creditors who are not favored?
This Article proposes that a proper solicitude is shown for the absolute priority rule when an interim or pre-plan settlement or other transaction with an insider, secured lender or other party who exercises some control over the debtor is subjected to higher bids in a market sale process such as an auction. This approach can provide a market valuation of the transaction and proposed distributions that can enable a bankruptcy court to determine whether the transaction includes a premium based on control that is proposed to be paid at the expense of other creditors, thus addressing the precise mischief sought to be remedied by the absolute priority rule.
The Jevic Court also left open the rule for bankruptcy court approval of first-day distributions that violate the absolute priority rule. This Article further contends that a market test for a “first-day” distribution to an employee, a critical vendor, or other creditor that is challenged as priority-skipping will be limited to whether the debtor sought and failed to obtain in the market the same good, service, or credit from an alternative supplier on the same or better terms than those proposed to be given by the firstday motion. A bankruptcy court in most cases will not be able to obtain, at the time of a first-day hearing, a market determination of what will be distributed to creditors months or years later when the case ends. And any hypothetical valuation that the court makes at a first-day hearing of the ultimate distributions to creditors in the case will be highly unreliable. Because of these obstacles, the question of whether a first-day payment ultimately will comport with distributional priorities should be replaced with the question of whether the debtor sought and failed to obtain an alternative supply in the market, and by a rebuttable presumption that preserving the going concern value of the chapter 11 debtor is likely, ultimately, to benefit even the disfavored creditors. This approach—which essentially adopts the occasionally maligned “doctrine of necessity” and rejects the Seventh Circuit’s Kmart rule — recognizes the disturbing weakness of a hypothetical determination made at the first day hearing of the ultimate distributions at the end of a chapter 11 case.
I conclude that a bankruptcy court demonstrates a proper solicitude for the absolute priority rule under both Jevic and 203 N. LaSalle when it relies on market exposure of pre-plan settlements and transactions to preclude control premiums to insiders or others who have some control over the debtor, and when it bases approval of first-day relief on a presumption of going concern value, rather than on speculative, hypothetical predictions of ultimate distributions to creditors at the end of the case. I suggest that these approaches to the approval of these types of interim and pre-plan transactions also can provide the certainty sought by the Court in Jevic
Keywords: bankrupty, chapter 11, creditors, absolute priority rule
JEL Classification: K20, K29
Suggested Citation: Suggested Citation