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Article: June 2017: Courts May Not Depart from the Bankruptcy Priority Rule in Chapter 11 Structured Dismissals

June 01, 2017
Business Litigation Reports

For more than a century, a cornerstone of federal bankruptcy law has been the absolute priority rule, which ensures that a debtor estate’s assets are distributed to senior and special classes of creditors over junior creditors. From the inception of this rule, parties have looked for ways to avoid its consequences, the most current of which was the use of a “structured dismissal.” In March of this year, the Supreme Court put an end to the use of structured dismissals as a means of bypassing absolute priority rules over the objection of an affected creditor, even in the “rarest” of cases. See Czyzewski v. Jevic Holding Corp. 137 S. Ct. 973, 978 (2017).

Legal Background
A business may file for bankruptcy under either Chapter 7 or Chapter 11 of the United States Bankruptcy Code. In a Chapter 7 bankruptcy, a trustee liquidates the debtor’s assets and distributes them to creditors. Czyzewski v. Jevic Holding Corp., 137 S.Ct. 973, 978 (2017) (citing 11 U.S.C. § 701 et seq.). In a Chapter 11 bankruptcy, a debtor business and its creditors negotiate a plan that will govern the distribution of the estate’s assets, often keeping the business operating as a going concern. Id. (citing §§ 1121, 1123, 1129 and 1141).

There are three possible outcomes to a Chapter 11 filing. The first is a bankruptcy-court confirmed plan that may keep the business operating while, at the same time, providing for payments to creditors. Id. at 979 (citing §§ 1123, 1129 and 1141). The second possible outcome is conversion of the case to a Chapter 7 liquidation. Id. (citing §§ 1112(a), (b) and 726). The third possible outcome is dismissal of the case, which aims to restore the pre-petition financial status quo. Id. (citing §§ 1112(b) and 349(b)(3)). The Bankruptcy Code recognizes that, in such a Chapter 11 dismissal, a perfect restoration may be difficult or impossible. The Code therefore allows the court to, “for cause,” alter the ordinary restorative consequences. Id. (citing § 349(b)). Such a dismissal is often referred to as a “structured dismissal,” and operates as a hybrid dismissal and confirmation order. Id.

Under the absolute priority rule, the Bankruptcy Code sets forth a system of priority that ordinarily determines the order in which a court will distribute the assets of the debtor estate. Secured creditors are highest on the priority list, followed by special classes of creditors, and then low priority creditors, such as general unsecured creditors and equity holders. Id. (citing §§ 507, 725 and 726). This prescribed order must be followed in Chapter 7 liquidations but the affected parties may agree to a different order in the Chapter 11 setting, where more flexibility exists. Id. Pursuant to the Bankruptcy Code, however, a court may not confirm a plan that violates the prescribed priority distribution order over the objection of an impaired creditor class. Id. (citing §§ 1129(a)(7) and (b)(2)). The Bankruptcy Code does not explicitly state if a bankruptcy court may deviate from the prescribed order in a structured dismissal.

Czyzewski et al. v. Jevic Holding Corp. et al.
In Czyzewski v. Jevic Holding Corp., Jevic, a trucking company, filed for bankruptcy under Chapter 11 after being purchased in a leveraged buyout. Following the bankruptcy, a court-authorized committee representing Jevic’s unsecured creditors sued the company’s senior secured creditors for fraudulent conveyance on behalf of the estate. The parties reached a settlement that called for a pro rata distribution of the estate’s assets to the unsecured creditors and dismissal of the Chapter 11 bankruptcy. Id. at 981. A group of former truck-drivers who held a priority wage claim against Jevic for failing to provide proper notice prior to termination were omitted from the settlement. The truck-drivers and the U.S. Trustee objected to the settlement, arguing that it violated the Code’s priority rules by paying general unsecured claims ahead of the truck-drivers’ mid-level priority claim. Id. The bankruptcy court approved the settlement, despite agreeing that the settlement’s distribution scheme failed to follow ordinary priority rules,. Id. at 981-82. The district court and the Third Circuit Court of Appeals affirmed. Id. at 982.

At the urging of the Solicitor General, who argued that the lower court was incorrect in approving the settlement, the Supreme Court agreed to hear the matter and, in a 6-2 opinion, reversed and remanded. In its ruling, the Court emphasized that the priority system applicable to Chapter 11 distributions is fundamental to the Bankruptcy Code’s operation. The Court therefore reasoned that “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,” it would expect to see some affirmative indication of intent from Congress. Id. at 984. The Court further reasoned that to the extent the dismissal sections of Chapter 11 foresee any transfer of assets, they seek a restoration of the pre-petition status. Id. (citing § 349 and H.R. Rep. No. 95-595).

While the Court acknowledged that § 349(b) of the Code provides that a bankruptcy court may, “for cause, order otherwise,” it held that this provision appears designed to give courts the flexibility to protect rights acquired in reliance on the bankruptcy case but not to allow an end-run around the basic principles of priority. Id. The word “cause,” the Court held, is too weak to justify the allowance of a priority-deviating final distribution of estate assets. Id.

The Court also addressed and rejected the Third Circuit’s finding that deviation from the prescribed priority rules may be appropriate in “rare” circumstances. The Court reasoned that allowing for any departures from the protections of the priority rules that Congress granted particular classes of creditors could have serious consequences, including changes in the bargaining power of different classes of creditors even in bankruptcies that do not end in structured dismissals, risks of collusion, and making settlement more difficult to achieve. Id. at 986-87.

In making its finding, the Court was careful to note that its decision was not contrary to any precedent from either the Court or from lower court decisions reflecting common bankruptcy practice. Id. at 985. It also distinguished the fact pattern in Jevic from those in other cases where lower courts had approved distributions that violated the ordinary priority rules, leaving intact decisions approving interim distributions such as first-day wage orders, critical vendor orders, and roll-ups, as well as the approval of a structured dismissal where no party with an economic stake objected to the dismissal. Id. at 985-86. Thus, while Jevic may mark the death knell of structured dismissals as a means of evading the priority rule over the objection of an affected party, the Court’s decision is written narrowly enough to leave in place significant flexibility for courts and parties to use structured dismissals in general.