United States: Supreme Court Limits Use Of Structured Dismissals Of Chapter 11 Cases

Richard Lear is a Partner and Amy Fuentes is an Associate in the Washington D.C. office

John Monaghan is a Partner in the Chicago office

HIGHLIGHTS:

  • In a 6-2 decision, the U.S. Supreme Court ruled in favor of the petitioners in Czyzewski, et al. v. Jevic Holding Corp, et al., reversing the decision of the U.S. Court of Appeals for the Third Circuit.
  • The Supreme Court determined that bankruptcy courts may not approve structured dismissals of Chapter 11 cases that provide for distributions of estate funds that do not follow the ordinary priority rules established under the Bankruptcy Code without the consent of the affected creditors.
  • As grounds for its decision, the Supreme Court considered the priority of claims under Section 507 and the effects of the dismissal of a bankruptcy case under Section 349 of the Bankruptcy Code, but declined to express its view on the legality of structured dismissals in general.

In a 6-2 decision on March 22, 2017, the U.S. Supreme Court determined that bankruptcy courts may not approve a structured dismissal of a Chapter 11 case that provided for distributions of estate funds that do not follow ordinary priority rules established under the U.S. Bankruptcy Code without the affected creditors' consent.1 In a decision written by Justice Stephen Breyer, the Supreme Court ruled in favor of the petitioner in Czyzewski, et al. v. Jevic Holding Corp., et al.2, reversing the decision of the U.S. Court of Appeals for the Third Circuit and remanding the case for further proceedings.3

Case History

In Jevic, the question before the Court was whether a bankruptcy court has the legal power to order a distribution of assets that gave money to high-priority secured creditors and low-priority general unsecured creditors but bypassed dissenting mid-priority unsecured creditors in connection with the dismissal of a Chapter 11 case.

In 2006, Sun Capital Partners acquired Jevic Transportation Corp. in a leveraged buyout. Two years later, Jevic filed a Chapter 11 case in Delaware. At the time of its bankruptcy filing, Jevic owed $53 million to senior secured creditors, including Sun, and more than $20 million to tax and general unsecured creditors. The petitioners, a group of former Jevic truck drivers, filed suit in the bankruptcy case against Jevic and Sun for violations of state and federal Worker Adjustment and Retraining Notification (WARN) Acts – laws that require a company to give workers at least 60 days' notice before their termination of employment. Petitioners alleged that Jevic did not provide proper notice to petitioners of the termination of their employment. The bankruptcy court granted summary judgment for the petitioners against Jevic, leaving them with a judgment of $12.4 million. Approximately $8 million of the judgment counted as a priority unsecured wage claim under the Bankruptcy Code and, accordingly, was entitled to payment ahead of general unsecured claims. The petitioners' WARN suit against Sun continued throughout most of the litigation that came before the Supreme Court. Eventually, Sun prevailed.

Another lawsuit relevant to the litigation before the Supreme Court resulted from the bankruptcy court authorizing a committee representing Jevic's unsecured creditors to sue Sun and the other secured creditor to avoid transfers of Jevic's assets in connection with the leveraged buyout as preferences under Section 547 of the Bankruptcy Code and as fraudulent transfers under Section 548 of the Bankruptcy Code. Any recovery from this lawsuit would inure to the benefit of the bankruptcy estate, not to the unsecured creditors. In 2011, the bankruptcy court held that the committee had adequately pleaded claims of preferential transfer and fraudulent transfer under the Bankruptcy Code.4 Following this ruling, the committee, Sun and the other secured creditor defendant and Jevic tried to negotiate a settlement. At that time, the only assets remaining in the bankruptcy estate were the preference and fraudulent conveyance claims that were the subject of the lawsuit and $1.7 million in cash, which was subject to a lien held by Sun.

The parties were successful in reaching a settlement agreement providing that: 1) the bankruptcy court would dismiss the lawsuit with prejudice; 2) Sun would assign its lien on Jevic's remaining $1.7 million to a trust, which would pay taxes and administrative expenses and distribute the remainder on a pro rata basis to the holders of the low priority claims, but which would not pay anything to the petitioners on their higher priority $8.3 million wage claims5; 3) the other secured creditor defendant would deposit $2 million into an account earmarked to pay the committee's legal fees and administrative expenses; and 4) Jevic's Chapter 11 case would be dismissed. As summarized by the Supreme Court, "the proposed settlement called for a structured dismissal that provided for distributions that did not follow ordinary priority rules."

Although the bankruptcy court agreed with petitioners that the settlement's proposed distribution to creditors did not follow the payment priority rules contained in the Bankruptcy Code, the bankruptcy court concluded that the failure did not bar approval of the settlement for two reasons: 1) the proposed payouts would occur pursuant to a structured dismissal of the bankruptcy case and not under a confirmed plan; and 2) without the settlement and dismissal, there would be "no realistic prospect" of a meaningful payment for anyone other than the secured creditors, constituting "dire circumstances" for the estate and its creditors. The U.S. District Court for the District of Delaware affirmed the bankruptcy court, agreeing that the priority rules were not a bar to approval because the settlement was not a Chapter 11 plan.6 The Third Circuit affirmed the district court, holding that structured dismissals need not always respect the distribution priority scheme under the Bankruptcy Code in "rare instances," such as the case at hand.7

Supreme Court Reverses Third Circuit Ruling

The Supreme Court reversed the Third Circuit ruling, stating that the Bankruptcy Code's priority system "constitutes a basic underpinning of business bankruptcy law" and that there was no indication that "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."

In its decision, the Supreme Court observed that Section 1112(b) of the Bankruptcy Code gave a bankruptcy court the power to dismiss a Chapter 11 case, but that neither "structured" nor "conditions" nor any other words about distributing estate assets or paying estate funds to creditors pursuant to a dismissal of the Chapter 11 case appeared in that section or in any relevant part of the Bankruptcy Code. Instead, the Supreme Court noted that Section 349(b) of the Bankruptcy Code provided that dismissal of a bankruptcy case restored the pre-petition financial status quo by, among other things, reinstating avoided transfers of estate property and revesting property of the bankruptcy estate in the entity in which such property was vested before the filing of the bankruptcy case. Acknowledging that Section 349(b) said that a bankruptcy court may, "for cause, orde[r] otherwise", the Supreme Court looked to the legislative history of that section and concluded that the provision appeared designed to give courts the flexibility to protect rights acquired by a party during the course of the bankruptcy case, a situation that did not exist in the Jevic case.

Finding no support in the Bankruptcy Code, other than possibly Section 349(b), for end-of-case distributions of estate assets to creditors of the kind that occur in Chapter 7 liquidations or under confirmed Chapter 11 plans as part of a dismissal of a bankruptcy case, the Supreme Court rejected the Third Circuit's approval of nonconsensual priority-violating structured dismissals even in "rare case[s]" in which courts could find "sufficient reasons" to disregard priority. Because of its view that it is difficult to adequately define "sufficient reasons," the Court concluded that a "rare case" exception could become a general rule resulting in potentially serious consequences in bankruptcy cases, including eliminating Congressional protections granted to particular classes of creditors, impacting the bargaining power of classes of creditors even in bankruptcy cases that do not result in structured dismissals, and promoting collusion between secured creditors and low-priority general unsecured creditors to freeze out priority unsecured creditors from receiving any distribution of estate assets.

Analysis

The Supreme Court noted in its decision that there was no express support in the Bankruptcy Code for structured dismissals and that structured dismissals appear to be used with increasing frequency. Yet, despite the juxtaposition of these circumstances, the Court parenthetically stated that it was not considering the far more interesting issue: the legality of structured dismissals in general. Instead, the Court determined that structured dismissals cannot be used to make a final distribution of estate funds in a manner that deviates from the priorities set forth in Section 507 of the Bankruptcy Code without the consent of the affected creditors.8 Consequently, the Jevic decision raised more questions than it answered. For example, would a structured dismissal that followed the priorities of Section 507 be permissible? Second, would the "gifting" by a secured creditor of funds that are proceeds of its collateral to be used to pay a low-priority creditor class, skipping a high-priority creditor class, in a structured dismissal be allowed? The funds at issue in Jevic were the proceeds of the settlement of fraudulent conveyance and preference litigation against the secured creditors, and were not proceeds of the secured creditors' collateral. Some courts have held that a secured creditor is free to allocate the proceeds of its collateral as it wishes. Perhaps those decisions are left unscathed, but perhaps they are not.9

The Court also made clear that it was not prohibiting all of what it termed as "priority-violating distributions." Actually, the Court seemed to approve of priority-violating distributions if they are made early in the case such that they do not constitute a final distribution of estate assets if those distributions serve to "preserve the debtor as a going concern", "make disfavored creditors better off" or "promote the possibility of a confirmable plan." Examples of such priority-violating distributions mentioned (and implicitly approved) by the Court include the non-controversial payment of employee pre-petition wages under a "first-day" order, and the far more controversial (and implicitly approved) priority-skipping distributions to "critical vendors" and roll-ups of pre-petition secured debt into post-petition financing by the secured creditor.

Footnotes

1 Structured dismissals are defined by the American Bankruptcy Institute as a "hybrid dismissal and confirmation order...that...typically dismisses the case while, among other things, approving certain distributions to creditors, granting certain third-party releases, enjoining certain conduct by creditors, and not necessarily vacating orders or unwinding transactions undertaken during the case." American Bankruptcy Institute Commission to Study the Reform of Chapter 11, 2012-2014 Final Report and Recommendations 270 (2014).    

2 Czyzewski, et al. v. Jevic Holding Corp, et al. (Slip Op., No. 15-649 March 22, 2017).

3 Justice Clarence Thomas filed a dissenting opinion.

4 In re Jevic Holding Corp., 2011 WL 4345204 (Bankr. D. Del. Sept. 15, 2011).

5 Apparently, Sun required that the distribution skip the petitioners' claims because the petitioners' WARN suit against Sun was still pending and Sun did not want to help finance the litigation against itself.

6 In re Jevic Holding Corp., 2014 WL 268613, *3 (D. Del. Jan. 24, 2014).

7 In re Jevic Holding Corp., 787 F.3d 173, 175, 180, 184 (3d Cir. 2017).

8 There is some question as to whether the Jevic decision addressed any existing split among the circuits as a result of petitioners recasting the question presented to the Court after the Court granted certiorari. Czyzewski, et al. v. Jevic Holding Corp, et al. (Slip Op., No. 15-649 March 22, 2017) (Thomas, J. dissenting opinion) ("[The recast question] is also not the subject of a circuit conflict").

9 The Court majority expressed concern with an approach to structured dismissals that promoted risks of collusion between senior secured creditors and representatives of general unsecured creditors "teaming up to squeeze out priority unsecured creditors." Jevic, Slip Op., at *17-18.

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