United States: Third Circuit Approves Structured Dismissal Of Chapter 11 Case That Includes Settlement Deviating From Bankruptcy Code's Priority Scheme

A "structured dismissal" of a chapter 11 case following a sale of substantially all of the debtor's assets has become increasingly common as a way to minimize costs and maximize creditor recoveries. However, only a handful of rulings have been issued on the subject, perhaps because bankruptcy and appellate courts are unclear as to whether the Bankruptcy Code authorizes the remedy.

The U.S. Court of Appeals for the Third Circuit recently weighed in on this issue in Official Committee of Unsecured Creditors v. CIT Group/Business Credit Inc. (In re Jevic Holding Corp.), 2015 BL 160363 (3d Cir. May 21, 2015). The court ruled that "absent a showing that a structured dismissal has been contrived to evade the procedural protections and safeguards of the plan confirmation or conversion processes, a bankruptcy court has discretion to order such a disposition." The court also held that "bankruptcy courts may approve settlements that deviate from the priority scheme of [the Bankruptcy Code]," but only if the court has "specific and credible grounds" to justify the deviation.

Structured Dismissals

In a typical successful chapter 11 case, a plan of reorganization or liquidation is proposed; the plan is confirmed by the bankruptcy court; the plan becomes effective; and, after the plan has been substantially consummated and the case has been fully administered, the court enters a final decree closing the case. Because chapter 11 cases can be prolonged and costly, prepackaged or prenegotiated plans and expedited asset sales under section 363(b) of the Bankruptcy Code have been increasingly used as methods to short-circuit the process, minimize expenses, and maximize creditor recoveries.

After a bankruptcy court approves the sale of substantially all of a chapter 11 debtor's assets under section 363(b), a number of options are available to deal with the debtor's vestigial property and claims against the bankruptcy estate and to wind up the bankruptcy case. Namely, the debtor can propose and seek confirmation of a liquidating chapter 11 plan, the case can be converted to a chapter 7 liquidation, or the case can be dismissed. The first two options commonly require significant time and administrative costs.

As a consequence, structured dismissals of chapter 11 cases following section 363(b) sales of substantially all of the debtors' assets have become a popular exit strategy. A "structured dismissal" is a dismissal conditioned upon certain elements agreed to in advance by stakeholders and then approved by the bankruptcy court, as distinguished from an unconditional dismissal of the chapter 11 case ordered by the court under section 1112(b) of the Bankruptcy Code. Structured dismissals have typically been granted in cases where: (i) the debtor has sold, with court authority, substantially all of its assets outside the plan context but is either administratively insolvent or lacks sufficient liquidity to fund the plan confirmation process; or (ii) after approval of a section 363(b) asset sale, the debtor has the wherewithal to confirm a liquidating chapter 11 plan, but costs associated with the confirmation process would likely eliminate or significantly reduce funds available for distribution to creditors.

Typical Terms

• Among the common provisions included in bankruptcy court orders approving structured dismissals are the following:
• Expedited procedures to resolve claims objections.
• Provisions specifying the manner and amount of distributions to creditors.
• Releases and exculpation provisions that might ordinarily be approved as part of a confirmed chapter 11 plan.
• Senior creditor carve-outs and "gifting" provisions, whereby, as a quid pro quo for a consensual structured dismissal, a senior secured lender or creditor group agrees to carve out a portion of its collateral from the sale proceeds and then "gift" it to unsecured creditors.
• Provisions that, notwithstanding section 349 of the Bankruptcy Code (vacating certain bankruptcy court orders when a case is dismissed), prior bankruptcy court orders survive dismissal and the court retains jurisdiction to implement the structured dismissal order; to resolve certain disputes; and to adjudicate certain matters, such as professional fee applications.

Sources of Authority

The Bankruptcy Code does not expressly authorize or contemplate structured dismissals. Even so, sections 105(a), 305(a)(1), and 1112(b) are commonly cited as predicates for the remedy.

Section 1112(b)(1) directs a bankruptcy court, on request of a party in interest and after notice and a hearing, to convert a chapter 11 case to a chapter 7 liquidation or to dismiss a chapter 11 case, "whichever is in the best interests of creditors and the estate, for cause." "Cause" is defined in section 1112(b)(4) to include, among other things, "substantial or continuing loss to or diminution of the estate and the absence of a reasonable likelihood of rehabilitation" and "inability to effectuate substantial consummation of a confirmed plan." Dismissal or conversion of a chapter 11 case under section 1112(b) is a two-step process. First, the court must determine whether "cause" exists for dismissal or conversion. Second, the court must determine whether dismissal or conversion of the case is in the best interests of the creditors and the estate. See, e.g., Rollex Corp. v. Associated Materials, Inc. (In re Superior Siding & Window, Inc.), 14 F.3d 240, 242 (4th Cir. 1994).

Section 305(a)(1) of the Bankruptcy Code provides that a bankruptcy court may dismiss or suspend all proceedings in a bankruptcy case under any chapter if "the interests of creditors and the debtor would be better served by such dismissal or suspension." Section 305(a)(1) has traditionally been used to dismiss involuntary cases where recalcitrant creditors involved in an out-of-court restructuring file an involuntary bankruptcy petition to extract more favorable treatment from the debtor. However, the provision has also been applied to dismiss voluntary cases, albeit on a more limited basis. Because an order dismissing a case under section 305(a) may be reviewed on appeal only by a district court or a bankruptcy appellate panel, rather than by a court of appeals or the U.S. Supreme Court (see 11 U.S.C. § 305(c)), section 305(a) dismissal is an "extraordinary remedy." See In re Kennedy, 504 B.R. 815, 828 (Bankr. S.D. Miss. 2014); see also Gelb v. United States (In re Gelb), 2013 BL 166941, *6 n.13 (B.A.P. 9th Cir. Mar. 29, 2013) (dismissal or suspension order under section 305(a) reviewable by bankruptcy appellate panel).

Section 105(a) of the Bankruptcy Code provides that a bankruptcy court "may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions" of the Bankruptcy Code. However, section 105(a) " 'does not allow the bankruptcy court to override explicit mandates of other sections of the Bankruptcy Code.' " Law v. Siegel, 134 S. Ct. 1188, 1194 (2014) (quoting 2 Collier on Bankruptcy ¶ 105.01[2], pp. 105‒06 (16th ed. 2013)).

Most structured dismissals are consensual. The few reported and unreported decisions on the issue reflect that some courts have been willing to order structured dismissals due to the consent of stakeholders and because a structured dismissal is a more expeditious, cost-effective, and beneficial means of closing a chapter 11 case. See, e.g., In re Naartjie Custom Kids, Inc., 2015 BL 223160 (Bankr. D. Utah July 13, 2015) (structured dismissal authorized as "an extraordinary remedy" under sections 305(c) and 349(b) of the Bankruptcy Code (the latter specifies the effects of dismissal, unless the court orders otherwise "for cause"); In re Buffet Partners, L.P., 2014 BL 207602,*4 (Bankr. N.D. Tex. July 28, 2014) (ruling that sections 105(a) and 1112(b) of the Bankruptcy Code provide authority for structured dismissals and approving structured dismissal, "emphasiz[ing] that not one party with an economic stake in the case has objected to the dismissal in this manner"); In re Felda Plantation, LLC, 2012 WL 1965964 (Bankr. N.D. Fla. May 29, 2012) (granting chapter 11 debtor's motion for structured dismissal in order, provided that, notwithstanding dismissal, all orders entered in bankruptcy survived dismissal, court retained jurisdiction to rule on fee applications, and debtor was obligated to pay U.S. Trustee and professional fees, as well as creditors, as specified); Omaha Standing Bear Pointe, L.L.C. v. Rew Materials (In re Omaha Standing Bear Pointe, L.L.C.), 2011 BL 69859 (Bankr. D. Neb. Mar. 17, 2011) (noting that chapter 11 debtor's motion for structured dismissal was granted after real property was sold free and clear and proceeds were distributed to secured creditor); see also In re Fleurantin, 420 Fed. Appx. 194, 2011 BL 80633 (3d Cir. Mar. 28, 2011) (ruling that bankruptcy court did not abuse its discretion in approving structured dismissal of individual chapter 7 case, which trustee argued "was in the best interests of the parties, particularly in light of the estate's continued expenditure of legal fees in response to [debtor's] motions and other efforts to obstruct its administration"). But see In re Biolitec, 2014 BL 355529 (Bankr. D.N.J. Dec. 16, 2014) (rejecting proposed structured dismissal as invalid under Bankruptcy Code); In re Strategic Labor, Inc., 467 B.R. 11, 11 and n.10 (Bankr. D. Mass. 2012) (stating that "[t]his matter offers an object lesson in how not to run a Chapter 11 case"; denying debtor's post-asset sale motion for approval of a structured dismissal, where, among other things, debtor intentionally mischaracterized secured claim of Internal Revenue Service and used cash collateral without authority; and instead granting U.S. Trustee's motion to convert to chapter 7).

Regardless of stakeholder consent, the Office of the U.S. Trustee, the division of the U.S. Department of Justice entrusted with overseeing the administration of bankruptcy cases, frequently objects to structured dismissals. The U.S. Trustee has argued, among other things, that structured dismissals: (i) distribute assets without adhering to statutory priorities; (ii) include improper and overbroad releases and exculpation clauses; (iii) violate the express requirements of section 349(b); (iv) may constitute "sub rosa" chapter 11 plans that seek to circumvent plan confirmation requirements and creditor protections; (v) improperly provide for retention of the bankruptcy court's jurisdiction; and (vi) fail to reinstate the remedies of creditors under applicable nonbankruptcy law. See Nan Roberts Eitel, T. Patrick Tinker & Lisa L. Lambert, Structured Dismissals, or Cases Dismissed Outside of Code's Structure?, 30 Am. Bankr. Inst. J. 20 (Mar. 2011).

The Bankruptcy Code's Priority Scheme

Secured claims enjoy the highest priority under the Bankruptcy Code. A claim is secured only to the extent that the value of the underlying collateral is equal to or greater than the face amount of the indebtedness. If this is not the case, the creditor will hold a secured claim in the amount of the collateral value, along with an unsecured claim for the deficiency. Applicable nonbankruptcy law and any agreements between and among the debtor and its secured creditors generally determine the relative priority of secured claims. However, the Bankruptcy Code provides for the creation of priming liens superior even to pre-existing liens under certain circumstances, in connection with financing extended to a debtor during a bankruptcy case.

The order of priority of unsecured claims is specified in section 507(a) of the Bankruptcy Code. Priorities are afforded to a wide variety of unsecured claims, including, among others, specified categories and (in some cases) amounts of domestic support obligations, administrative expenses, employee wages, taxes, and certain wrongful death damages awards.

In a chapter 7 case, the order of priority of the distribution of unencumbered estate 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 claimants of equal priority within each of the six categories of claims 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 lower category claimants.

In a chapter 11 case, the chapter 11 plan determines the treatment of secured and unsecured claims (as well as equity interests) in accordance with the provisions of the Bankruptcy Code. If a creditor does not agree to "impairment" of its claim under a 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 are: (i) the creditor must receive at least as much under the plan as it would receive in a chapter 7 case (section 1129(a)(7)), a requirement that incorporates the priority and distribution schemes delineated in sections 507(a) and 726; 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 requirement is sometimes referred to as the "absolute priority rule."

In Jevic Holding, the Third Circuit addressed the validity of a settlement deviating from the Bankruptcy Code's priority scheme as part of a structured dismissal.

Jevic Holding

Jevic Transportation, Inc. ("Jevic") was a New Jersey-based trucking company. In 2006, the financially troubled company was acquired in a leveraged buyout by a subsidiary of private-equity firm Sun Capital Partners, Inc. ("Sun Capital"). The transaction was financed by a group of lenders led by CIT Group Business Credit Inc. ("CIT").

Jevic's financial situation continued to deteriorate. On May 19, 2008, Jevic ceased operating and notified its employees that they were being terminated, effective immediately. Jevic filed for chapter 11 protection in the District of Delaware on May 20, 2008. 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.

A group of Jevic's terminated truck driver employees (the "Drivers") commenced a class action adversary proceeding 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. In a separate action, 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 obligations incurred during the leveraged buyout were avoidable as preferences and fraudulent transfers.

After the court granted and denied in part the defendants' motions to dismiss the Committee's complaint, the parties convened in March 2012 to negotiate a settlement of the dispute. By that time, substantially all of Jevic's assets had been liquidated 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 avoidance claims against CIT and Sun Capital.

The Committee, Jevic, CIT, and Sun Capital reached a settlement whereby, among other things: (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 the avoidance action would be dismissed; and (iv) Jevic's chapter 11 case would then be dismissed. The parties jointly sought bankruptcy court approval of the settlement and the structured dismissal.

The Drivers, whose WARN Act claims were not covered by the settlement, and the U.S. Trustee objected. Although the Drivers' claims had not been liquidated, the Drivers estimated that their claims amounted to approximately $12.4 million, of which $8.3 million was entitled to priority as a wage claim under section 507(a)(4) of the Bankruptcy Code. According to the Drivers and the U.S. Trustee, the proposed settlement and structured dismissal should not be approved because: (i) the settlement would distribute property of the estate to creditors of lower priority than the Drivers without paying their more senior priority claims; and (ii) the Bankruptcy Code does not authorize structured dismissals.

The bankruptcy court acknowledged that the Bankruptcy Code does not expressly authorize the distributions and dismissal contemplated by the settlement motion. Even so, noting that other courts have granted similar relief, the court concluded 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."

The bankruptcy court also rejected the argument that the settlement should not be approved because it distributed estate assets in violation of the absolute priority rule. Although chapter 11 plans must comply with the Bankruptcy Code's priority scheme, the court noted, settlements need not do so.

Instead, the bankruptcy court applied the multifactor test articulated in In re Martin, 91 F.3d 389, 393 (3d Cir. 1996), to assess the propriety of the settlement under Rule 9019 of the Federal Rules of Bankruptcy Procedure. Under this test, the court considers: (i) the probability of success in the litigation; (ii) the likely difficulties in collecting on a judgment; (iii) the complexity of the litigation, as well as the cost, inconvenience, and delay associated with it; and (iv) the paramount interests of creditors.

The bankruptcy court found, among other things, that the Committee's likelihood of success in the avoidance action was "uncertain at best," given the legal impediments to recovery, the substantial resources of the defendants, and the scarcity of estate funds. Confronted, in its view, with either "a meaningful recovery or zero," the bankruptcy court ruled that "[t]he paramount interest of the creditors mandates approval of the settlement" and nothing in the Bankruptcy Code dictates otherwise. It accordingly approved the settlement and the structured dismissal of Jevic's chapter 11 case.

After the U.S. District Court for the District of Delaware affirmed on appeal, the Drivers appealed to the Third Circuit.

The Third Circuit's Ruling

A three-judge panel of the Third Circuit affirmed in a split decision. At the outset, writing for the majority, circuit judge Thomas M. Hardiman noted that "[t]his appeal raises a novel question of bankruptcy law: may a case arising under Chapter 11 ever be resolved in a 'structured dismissal' that deviates from the Bankruptcy Code's priority system?" He concluded that "in a rare case, it may."

Structured Dismissal May Be Authorized

Judge Hardiman agreed with the Drivers that, although structured dismissals have been approved with increasing frequency, the Bankruptcy Code does not expressly authorize such dismissals. He also acknowledged that Congress "would have spoken more clearly if it had intended to leave open an end run around the procedures that govern plan confirmation and conversion to Chapter 7." Even so, the judge rejected as overbroad the Drivers' argument that the position staked out by the settlement proponents overestimated the breadth of a bankruptcy court's settlement-approval power under Rule 9019, " 'render[ing] plan confirmation superfluous' and paving the way for illegitimate sub rosa plans engineered by creditors with overwhelming bargaining power."

According to Judge Hardiman, those concerns are relevant only if a structured dismissal is used to circumvent the plan confirmation process or conversion to chapter 7. In Jevic's case, Judge Hardiman stated, the evidence showed that there was no prospect of a confirmable plan for Jevic and that conversion to chapter 7 "was a bridge to nowhere." Accordingly, the majority ruled that "absent a showing that a structured dismissal has been contrived to evade the procedural protections and safeguards of the plan confirmation or conversion processes, a bankruptcy court has discretion to order such a disposition."

Settlement That Deviates From the Code's Priority Scheme Permitted

Next, Judge Hardiman considered whether a settlement in the context of a structured dismissal "may ever skip a class of objecting creditors in favor of more junior creditors." For guidance, he looked to the rulings of two sister circuits that had previously grappled with this question. In Matter of AWECO, Inc., 725 F.2d 293 (5th Cir. 1984), the Fifth Circuit rejected a settlement that would have transferred litigation proceeds to an unsecured creditor without paying senior creditors in full. The Fifth Circuit held that chapter 11's "fair and equitable" standard, which requires compliance with the priority scheme, applies to settlements.

The Second Circuit adopted a more flexible approach in In re Iridium Operating LLC, 478 F.3d 452, 463–64 (2d Cir. 2007). There, the court rejected the Fifth Circuit's approach as "too rigid," ruling that the absolute priority rule "is not necessarily implicated" when "a settlement is presented for court approval apart from a reorganization plan." Instead, the Second Circuit held that:

In Jevic, the majority agreed with the Second Circuit's approach in Iridium. Given the " 'dynamic status of some pre-plan bankruptcy settlements,' " Judge Hardiman wrote, "it would make sense for the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure to leave bankruptcy courts more flexibility in approving settlements than in confirming plans of reorganization" (quoting Iridium, 478 F.3d at 464). However, echoing a concern expressed by the Second Circuit in Iridium, he cautioned that compliance with the Bankruptcy Code's priorities will ordinarily be dispositive of whether a proposed settlement is fair and equitable. "Settlements that skip objecting creditors in distributing estate assets," Judge Hardiman wrote, "raise justifiable concerns about collusion among debtors, creditors, and their attorneys and other professionals."

Judge Hardiman acknowledged that the propriety of the settlement among Jevic, Sun Capital, CIT, and the Committee was "a close call." Even so, he concluded that the bankruptcy court had sufficient reason to approve the settlement and the structured dismissal of Jevic's chapter 11 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.' "

Dissent

Judge Anthony J. Scirica filed a dissenting opinion. According to him, the settlement should not have been approved because it is "at odds with the goals of the Bankruptcy Code." He explained that, had the settlement's departure from the statute's priority scheme been necessary to maximize the estate's overall value, he would have had no objection. However, Judge Scirica wrote that:

As such, he concluded that the settlement and structured dismissal raise the same concern as transactions invalidated under the sub rosa plan doctrine. In short, he wrote, the settlement "appears to constitute an impermissible end-run around the carefully designed routes by which a debtor may emerge from Chapter 11 proceedings."

Judge Scirica acknowledged that, if the settlement were vacated, Jevic's chapter 11 case would likely be converted to a chapter 7 liquidation in which secured creditors would be the only creditors to recover anything. As a consequence, the judge noted that he "would not unwind the settlement entirely." Instead, he would: (i) permit the secured creditors to retain their releases; (ii) allow administrative creditors to keep their distributions; but (iii) force unsecured creditors to disgorge their distributions, which should then be distributed pro rata to pay the priority wage claims of the Drivers, with any surplus to be distributed to other creditors in accordance with the Bankruptcy Code's priority scheme.

Outlook

Jevic Holdings is undoubtedly a positive development for proponents of structured dismissals as a means of maximizing creditor recoveries and keeping down costs. The approach sanctioned by the Third Circuit gives bankruptcy judges the flexibility, by means of a structured dismissal, to salvage some measure of recovery for parties other than secured creditors in a case where no chapter 11 plan could be confirmed and conversion to chapter 7 would only add another layer of administrative costs.

The final report issued on December 8, 2014, by the American Bankruptcy Institute Commission to Study the Reform of Chapter 11 recommended that rules governing section 363(b) sales be amended to build some of the features commonly included in structured dismissal orders into orders authorizing the sale of all or substantially all of a debtor's assets. If this proposal were adopted, the Commission stated, structured dismissals should be unnecessary, and courts could comply strictly with the Bankruptcy Code in connection with orders ending chapter 11 cases. It remains to be seen whether Congress will adopt this view in any future amendments to the Bankruptcy Code.

Pending congressional consideration of any such amendments, any concern about the Third Circuit's approval of the Jevic Holdings settlement, which deviated from the Bankruptcy Code's priority scheme by depriving an entire class of priority unsecured creditors of any recovery whatsoever, may be overblown. In its opinion, the majority noted that the Drivers were late in coming to the negotiating table and, more significantly, that Sun Capital, which was a defendant in the WARN Act litigation, was not eager to allow its cash collateral to be used to fund litigation against itself.

The perceived injustice of this "class skipping" in the settlement was apparently the principal provocation for Judge Scirica's dissent, as it clearly motivated his argument that the settlement should be modified to rectify the deviation. However, the funds earmarked in the settlement for paying unsecured creditors were subject to Sun Capital's liens. Thus, the settlement can be viewed as a senior-class "gift," a practice that has been sanctioned by some courts in approving a settlement or chapter 11 plan despite the absence of strict compliance with the Bankruptcy Code's priority scheme. See, e.g., In re Journal Register Co., 407 B.R. 520 (Bankr. S.D.N.Y. 2009); In re World Health Alternatives, Inc., 344 B.R. 291 (Bankr. D. Del. 2006). But see DISH Network Corp. v. DBSD N. Am., Inc. (In re DBSD N. Am., Inc.), 634 F.3d 79 (2d Cir. 2011); In re Armstrong World Indus., 432 F.3d 507 (3d Cir. 2005).

On July 6, 2015, the Drivers petitioned for a rehearing en banc of the Third Circuit's ruling. The Drivers argued in their petition, among other things, that the decision clashes with AWECO and Iridium. "Review by the full court is warranted," the Drivers contended, "to ensure the uniformity of federal law on a question of considerable and increasing importance to bankruptcy law."

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