United States: U.S. Supreme Court Holds That Structured Dismissals Cannot Deviate From The Bankruptcy Code's Priority Scheme

In bankruptcy cases under chapter 11, debtors sometimes opt for a "structured dismissal" when a consensual plan of reorganization or liquidation cannot be reached or conversion to chapter 7 would be too costly. In Czyzewski v. Jevic Holding Corp., 137 S. Ct. 973, 2017 BL 89680 (U.S. Mar. 27, 2017), the U.S. Supreme Court held that the Bankruptcy Code does not allow bankruptcy courts to approve distributions in structured dismissals which violate the Bankruptcy Code's ordinary priority rules. The Court rejected a Third Circuit decision that had allowed for such structured dismissals in "rare" circumstances. As a result of Jevic, structured dismissals are likely to become more difficult to craft. The Supreme Court's opinion, however, leaves room for the creative use of settlements that provide only for interim (rather than final) distributions deviating from the Bankruptcy Code's priority scheme, and the Court did not directly question the use of settlements that involve "gifts" from senior to junior creditors.

Structured Dismissals

Chapter 11 cases are concluded in one of three ways: confirmation of a plan of reorganization or liquidation, conversion to a chapter 7 case, or dismissal of the case. Dismissal usually restores the parties' financial position to the prepetition status quo. When the financial status of debtors and creditors has been altered during the bankruptcy case in such a way as to make perfect restoration impossible, section 349(b) of the Bankruptcy Code allows the bankruptcy court to dismiss a case without such complete reversion "for cause." For example, courts have relied on this "for cause" provision to approve dismissals that provide for other rights and protections typically seen in a confirmation order, including distributions to creditors. Such dismissals are commonly known as "structured dismissals."

The Bankruptcy Code sets forth certain priority rules governing distributions to creditors in both chapter 11 and chapter 7 cases. Secured claims enjoy the highest priority under the Bankruptcy Code. The Bankruptcy Code then recognizes certain priority unsecured claims, including claims for administrative expenses, wages, and certain taxes. General unsecured claims come next in the priority scheme, followed by any subordinated claims and the interests of equity holders.

In a chapter 7 case, the order of priority for the distribution of unencumbered assets is determined by section 726 of the Bankruptcy Code. The order of distribution ranges from payments on claims in the order of priority specified in section 507(a), which have the highest priority, to payment of any residual assets to the debtor, which has the lowest priority. Distributions are to be made pro rata to parties of equal priority within each of the six categories specified in section 726. If claimants in a higher category of distribution do not receive full payment of their claims, no distributions can be made to parties in lower categories.

In a chapter 11 case, the chapter 11 plan determines the treatment of secured and unsecured claims (as well as equity interests), subject to the requirements of the Bankruptcy Code. If a creditor does not agree to "impairment" of its claim under the plan—such as by agreeing to receive less than payment in full—and votes to reject the plan, the plan can be confirmed only under certain specified conditions. Among these conditions are the following: (i) the creditor must receive at least as much under the plan as it would receive in a chapter 7 liquidation; and (ii) the plan must be "fair and equitable." Section 1129(b)(2) of the Bankruptcy Code provides that a plan is "fair and equitable" with respect to a dissenting impaired class of unsecured claims if the creditors in the class receive or retain property of a value equal to the allowed amount of their claims or, failing that, if no creditor or equity holder of lesser priority receives any distribution under the plan. This is known as the "absolute priority rule."

The Bankruptcy Code does not expressly state whether these priority rules apply to structured dismissals, and until Jevic, precedent concerning this issue was sparse and inconsistent.

Jevic Background

Jevic Transportation, Inc. ("Jevic"), a New Jersey-based trucking company, filed for chapter 11 protection in Delaware on May 20, 2008. Two years earlier, a subsidiary of private-equity firm Sun Capital Partners, Inc. ("Sun Capital") had purchased Jevic in a leveraged buyout. Sun Capital borrowed from a group of lenders led by CIT Group Business Credit Inc. ("CIT") to finance the transaction. After the leveraged buyout, Jevic's financial health declined. On May 19, 2008, Jevic ceased operations and terminated its employees. The company filed for chapter 11 protection the following day in the District of Delaware. As of the petition date, Jevic owed approximately $53 million to its first-priority secured lenders (CIT and Sun Capital) and more than $20 million to taxing authorities and general unsecured creditors.

Two lawsuits followed from the events leading up to Jevic's bankruptcy. First, a group of Jevic's terminated truck driver employees (the "Drivers") commenced a class action against Jevic and Sun Capital, alleging that they had been given insufficient notice of termination under federal and state Worker Adjustment and Retraining Notification (WARN) Acts. Second, the official unsecured creditors' committee (the "Committee") sued Sun Capital and CIT on behalf of the estate, claiming, among other things, that the transfers made and the obligations incurred during the leveraged buyout were avoidable as preferential and fraudulent transfers (the "Committee Action").

Eventually, in 2012, Sun Capital, CIT, Jevic, and the Committee reached a settlement that resolved the Committee Action (the "Settlement"). By this time, Jevic had already liquidated substantially all of its assets to repay the lender group led by CIT. The only remaining assets consisted of $1.7 million in cash (encumbered by Sun Capital's lien) and the Committee's avoidance claims against CIT and Sun Capital. The Settlement provided, among other things, that: (i) CIT would pay $2 million into an account earmarked for the payment of legal fees and other administrative expenses; (ii) Sun Capital would release its lien on the remaining $1.7 million in cash, which would be distributed under a trust to tax and administrative creditors, with any remaining cash to be distributed to general unsecured creditors on a pro rata basis; (iii) the parties would exchange releases; and (iv) the Committee Action would be dismissed. Upon the consummation of these items, Jevic's chapter 11 case would then be dismissed (the above transactions being referred to as the "Structured Dismissal"). Over the objections of the Drivers and the United States Trustee, the bankruptcy court approved the Structured Dismissal.

The Drivers estimated that their claims amounted to approximately $12.4 million, with $8.3 million entitled to priority as wage claims under section 507(a)(4) of the Bankruptcy Code. The Drivers and the United States Trustee opposed the Structured Dismissal on two main grounds: (i) the Bankruptcy Code does not authorize structured dismissals; and (ii) the proposed distributions violated the absolute priority rule.

The bankruptcy court agreed that the Bankruptcy Code does not expressly authorize structured dismissals. Nevertheless, the court noted that "the dire circumstances that are present in this case warrant the relief requested here." Specifically, the court found that: (a) absent approval of the settlement, there was "no realistic prospect" of a meaningful distribution to anyone other than secured creditors; (b) there was "no prospect" of a confirmable chapter 11 plan (of either reorganization or liquidation); and (c) conversion to a chapter 7 liquidation would have been unavailing because a chapter 7 trustee would not have sufficient funds "to operate, investigate or litigate."

Addressing the second argument, the bankruptcy court noted that, even though chapter 11 plans must comply with the Bankruptcy Code's priority scheme, settlements are not subject to this rule. After analyzing the Settlement under the standard applicable to the approval of a compromise or settlement under Rule 9019 of the Federal Rules of Bankruptcy Procedure ("Bankruptcy Rule 9019")—namely, the probability of success in litigation, difficulties in collection, the litigation's complexity, attendant expense, inconvenience and delay, and the paramount interests of creditors—the bankruptcy court approved the Structured Dismissal.

The Drivers appealed to the district court, which affirmed. The Drivers then appealed to the Third Circuit, and a three-judge panel affirmed the district court in a 2-to-1 decision. Writing for the majority, circuit judge Thomas Hardiman stated that even though the Bankruptcy Code does not provide for structured dismissals, such dismissals are permitted in "rare" circumstances. Judge Hardiman noted that the Bankruptcy Code provides greater flexibility with respect to approving settlements than approving a chapter 11 plan. Nevertheless, the majority cautioned that compliance with the Bankruptcy Code's creditor priority scheme is ordinarily dispositive of settlements presented under Bankruptcy Rule 9019 because "[s]ettlements that skip objecting creditors in distributing estate assets raise justifiable concerns about collusion among debtors, creditors, and their attorneys and other professionals."

The Third Circuit majority went on to find that structured dismissals can provide for distributions which conflict with the priority scheme only in a "rare case." According to the majority, Jevic was one of those "close call[s]" and a "rare case." The Third Circuit majority concluded that there were sufficient facts in the bankruptcy court's record approving the Structured Dismissal to be such a rare case. According to Judge Hardiman, "This disposition, unsatisfying as it was, remained the least bad alternative since there was 'no prospect' of a plan being confirmed and conversion to chapter 7 would have resulted in the secured creditors taking all that remained of the estate in 'short order.' "

The Supreme Court's Opinion

In a 6-2 opinion issued on March 22, 2017, the Supreme Court reversed and remanded the Third Circuit's holding.

After finding that the petitioners (the Drivers) had standing, the Court examined whether the bankruptcy court had authority to "approve a structured dismissal that provides for distributions that do not follow ordinary priority rules without the affected creditors' consent." The Court outlined the importance of the creditor priority scheme embodied in the Bankruptcy Code and ultimately held that the Bankruptcy Code does not provide bankruptcy courts with the power to deviate from the priority scheme when approving dismissals. Justice Breyer, writing for the majority, stated that "we would expect to see some affirmative indication of intent if Congress actually meant to make structured dismissals a backdoor means to achieve the exact kind of nonconsensual priority-violating final distributions that the Code prohibits in Chapter 7 liquidations and Chapter 11 plans."

The Court went on to hold that Congress did not intend to allow the "for cause" standard in section 349(b) to give bankruptcy courts the authority to approve structured dismissals which contravene the absolute priority rule. Justice Breyer recognized that creditors rely on the Bankruptcy Code's priority scheme, writing that "the word 'cause' is too weak a reed upon which to rest so weighty a power" and that section 349 was instead designed to "give courts the flexibility to 'make the appropriate orders to protect rights acquired in reliance on the bankruptcy case.' "

The Court distinguished cases where courts have approved interim settlements that distributed estate assets in violation of the priority rules, particularly In re Iridium Operating LLC, 478 F.3d 452 (2d Cir. 2007), from Jevic, which involved final distributions pursuant to the Structured Dismissal. The Supreme Court found that Iridium "does not state or suggest that the Code authorizes nonconsensual departures from ordinary priority rules in the context of a dismissal—which is the final distribution of estate value—and in the absence of any further unresolved bankruptcy issues." In this sense, the Court explained, the situation in Iridium is similar to certain "first-day" orders, where courts have allowed for, among other things, payments ahead of secured and priority creditors to employees for prepetition wages or to "critical vendors" on account of their prepetition invoices. However, the Court explained that "in such instances one can generally find significant Code-related objectives that the priority-violating distributions serve." By contrast, the Structured Dismissal served no such objectives—it did not benefit disfavored creditors by preserving the debtor as a going concern in order for the debtor to possibly emerge under a confirmable plan of reorganization.

Finally, the Court determined that there can be no "rare case" exception to the general rule that structured dismissals must follow ordinary priority rules. Justice Breyer cautioned that bankruptcy and other courts will likely find "sufficient reasons" to provide a basis for deviating from the priority rules in "rare cases." Also, he noted, such a standard would prove difficult for courts to apply and "threaten to turn a 'rare case' exception into a more general rule." Using Jevic as an example, the Court noted that many chapter 11 cases with structured dismissals contain some degree of uncertainty regarding what could happen if the case were not dismissed. In Jevic, the Court appears to have concluded that there was reason to believe that, without the Structured Dismissal, the parties would have returned to the negotiating table and reached a new settlement which would have honored the Bankruptcy Code's priority scheme.

The Dissent

Justices Thomas and Alito dissented from the majority opinion on procedural grounds. In his dissent, Justice Thomas argued that the writ of certiorari should have been dismissed as improvidently granted. According to him, the Court granted certiorari to decide a different question than the one answered by the Court in the majority opinion. The Court had granted certiorari to decide "whether a bankruptcy court may authorize the distribution of settlement proceeds in a manner that violates the statutory priority scheme." While lower courts of appeal are divided on this issue, Justice Thomas found no indication that lower courts had yet addressed whether a bankruptcy court may authorize structured dismissals allowing for distributions in a manner which violates the statutory priority scheme. Moreover, according to Justice Thomas, the Drivers had reframed the question presented to the Court only after certiorari had been granted on the broader question. Without the benefit of lower courts' consideration of, and Jevic's briefing on, this narrower issue, Justice Thomas argued that the appeal should have been dismissed.

Outlook

While the Court's ruling in Jevic is significant in its own right, the opinion is equally significant for what it implies. First, the Court expressly stated that it was not providing a "view about the legality of structured dismissals in general." In theory, this leaves open the possibility for structured dismissals, but such dismissals will likely become more difficult to craft after Jevic. Second, and perhaps more important, the Court suggested that bankruptcy courts have the authority to approve settlements contemplating priority-violating interim distributions. Going forward, savvy debtors and creditors may move away from structured dismissals and toward settlement agreements that provide for interim distributions of some of a debtor's assets.

Last, Jevic serves as a caution light for debtors and creditors when crafting settlements that involve "gifting" from secured creditors to junior unsecured creditors. In those instances, distributions are considered "gifts" because they are purportedly made from secured creditors' collateral, not estate assets. Although Jevic never refers to this practice, the emphasis placed on adherence to the Bankruptcy Code's priority scheme in final distributions may subject gifting provisions to attack by unhappy creditors who were passed over.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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