Avoiding settlement agreements through higher-priority security interests
Last month, the U.S. Supreme Court decided a bankruptcy case that includes relevant lessons and considerations for lenders, investors and those manufacturers that finance the purchase of their goods.
At issue was whether a bankruptcy court has the authority to confirm a settlement agreement in conjunction with the dismissal of a bankruptcy filing when the settlement agreement violates the priority for distributions set forth by the Bankruptcy Code and the impaired creditors have not consented to the settlement agreement.
Lenders, investors and manufacturers are aware of the importance of assuring proper actions are taken to assure priority of payment. Assuring proper security has been obtained in conjunction with the extension of funds or goods is essential for establishing rights to repayment and for protecting against the financial instability of the borrower or customer. There are many different ways to obtain priority, including entering into a formal security agreement and perfecting the same in the manner provided by the Uniform Commercial Code or retaining an interest in a machine or tool under Michigan’s Special Tools Lien Act.
In the case of Czyzewski v. Jevic Holding Corp., a group of employees won a claim against an employer that had failed to provide proper notice of termination under the WARN ACT, which requires employers to notify employees their jobs will be terminated in conjunction with a mass layoff or the closing of a company.
As a result of their successful case, the workers obtained a claim against Jevic, the company undergoing reorganization in bankruptcy, which was higher in priority than the claims of Jevic’s unsecured creditors. Despite having a higher priority claim, the bankruptcy court determined the insolvency of Jevic posed “dire circumstances” for the bankruptcy estate because it was likely no funds would exist for any creditors other than the secured creditors if the bankruptcy case was allowed to proceed. Thus, a settlement agreement that paid unsecured creditors before paying the employees’ claim was approved by the court.
After affirmation of the bankruptcy court’s decision by the District Court and the Third Circuit Court of Appeals, the Supreme Court reversed the bankruptcy court’s holding. Ultimately, the Supreme Court determined the priority rules set forth by the Bankruptcy Code are remarkably important for maintaining certainty both under the law and in the marketplace, that Congress has not provided for an exception to the priority rules in the context of the dismissal of a bankruptcy case, and that it was unadvisable to create conditions under which debtors may have an incentive to determine most favored creditors in contravention of the intent of the law. The case does suggest if the employees had approved the settlement agreement that it may have been permitted to stand.
For lenders, investors and manufacturers, the lesson of Czyzewski is that properly obtaining and perfecting security interests is remarkably important in creating security for payments owed. In this case, despite the increasing trend toward prepackaged bankruptcy settlements, the successful parties were those with the higher priority claims. Even in instances when a lender, investor or manufacturer has a positive relationship with a client and may be able to obtain a favorable settlement, this case demonstrates the law may seek to first protect senior secured parties, so proper security interests should be obtained and perfected in a timely fashion.